**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      DC 20549**





**_________________**





**FORM
      10-Q**


**_________________**





**(Mark
      One)**


**x** **Quarterly
      report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934**





**For
      the quarterly period ended September 30, 2005**





**OR**





**oTransition
      report
      pursuant to Section 13 of 15(d) of the Securities Exchange Act of
      1934**





**Commission
      File Number: 001-32634**


**_________________**





**SMART
      ONLINE, INC.**


**(Exact
      name of registrant as specified in its charter)**





**_________________**








**Delaware**
            **95-4439334****(State
                of other jurisdiction of**
            **(IRS
                Employer****incorporation
                or organization)**
            **Identification
                No.)**








**2530
      Meridian Parkway, 2nd Floor**


**Durham,
      North Carolina 27713**


**(Address
      of principal executive offices)**





**(919)
      765-5000**


**(Registrant’s
      telephone number, including area code)**


**_________________**





Indicate
      by check mark whether the Registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days: Yes þ No o





Indicate
      by check mark whether the Registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).  Yes o No þ




Indicate
      by check mark whether the Registrant is an accelerated filer (as described
      in
      Rule 12b-2 of the Securities Exchange Act of 1934). Yes o No þ





As
      of
      September 30, 2005, there were approximately 13,664,622 million shares of the
      Registrant’s Common Stock outstanding.







Index








**Smart
      Online, Inc.**





**INDEX**








**PART
      I.  FINANCIAL INFORMATION**





**Page
                No.****Item
                1.**
            **Financial
                Statements:**
            3Balance
                Sheets as of September 30, 2005 (unaudited) and
                December 31, 2004
            3Statements
                of Operations (unaudited) for the three months and
                nine months ended September 30, 2005 and 2004
            4Statements
                of Cash Flows (unaudited) for the three
                months and nine months ended September 30, 2005 and
                2004
            5Notes
                to Financial Statements
                (unaudited)
            7**Item
                2.**
            **Management’s
                Discussion and Analysis of Financial Condition
                and Results of Operations (including Risk
                Factors)**
            19**Item
                3.**
            **Quantitative
                and Qualitative Disclosures About Market
                Risk**
            61**Item
                4.**
            **Controls
                and Procedures**
            61**PART
                II. OTHER INFORMATION****Item
                1.**
            **Legal
                Proceedings**
            62**Item
                2.**
            **Unregistered
                Sales of Equity Securities and Use of
                Proceeds**
            62**Item
                3.**
            **Defaults
                Upon Senior
                Executives**
            62**Item
                4.**
            **Submission
                of Matters to a Vote of Securities
                Holders**
            62**Item
                5.**
            **Other
                Information**
            63**Item
                6.**
            **Exhibits**
            63**Signatures**
            64








2
 Index


**PART
      I.   FINANCIALINFORMATION**





**Item
      1.   FINANCIALSTATEMENTS**





**Smart
      Online, Inc.**


**BalanceSheets**





**Assets**
            
            
            **September
                30, 2005**
              **(unaudited)**
            
            
            **December
                31**,
              **2004**CURRENT
                ASSETS:Cash
                and cash equivalents
            
            $
            3,959,300
            
            $
            173,339Marketable
                securities
            
            
            -
            
            
            395,000Accounts
                receivable, net
            
            
            49,906
            
            
            30,904Other
                accounts receivable
            
            
            29,309
            
            
            43,455Prepaid
                expenses
            
            
            506,995
            
            
            24,850Total
                current assets
            
            
            4,545,510
            
            
            667,548PROPERTY
                AND EQUIPMENT, net
            
            
            155,524
            
            
            75,636INTANGIBLE
                ASSETS, net
            
            
            120,246
            
            
            16,623OTHER
                ASSETS
            
            
            13,540
            
            
            13,894TOTAL
                ASSETS
            
            $
            4,834,820
            
            $
            773,701CURRENT
                LIABILITIES:Accounts
                payable
            
            $
            360,209
            
            $
            186,382Accrued
                payroll
            
            
            215,563
            
            
            110,079Accrued
                payroll taxes, penalties and interest
            
            
            10,531
            
            
            574,707Accrued
                liabilities
            
            
            67,590
            
            
            120Deferred
                revenue
            
            
            361,722
            
            
            721,689Total
                current liabilities
            
            
            1,015,615
            
            
            1,592,977LONG-TERM
                LIABILITIES:Deferred
                compensation, notes payable and interest
            
            
            -
            
            
            1,091,814Total
                liabilities
            
            
            1,015,615
            
            
            2,684,791COMMITMENTS
                AND CONTINGENCIES
            
            
            -
            
            
            -STOCKHOLDERS'
                EQUITY (DEFICIT):Common
                stock, $.001 par value, 45,000,000 shares authorized, shares issued
                and
                outstanding:
              September
                30, 2005 - 13,664,622; December 31, 2004 —11,631,832
            
            
            13,665
            
            
            11,632Additional
                paid-in capital
            
            
            43,873,911
            
            
            34,809,832Accumulated
                deficit
            
            
            40,068,311
            
            
            (36,732,554
            )Total
                stockholders' equity (deficit)
            
            
            3,819,205
            
            
            (1,911,090
            )TOTAL
                LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
            
            $
            4,834,820
            
            $
            773,701








See
      Notes
      to Financial Statements





3
 Index


**SMART
      ONLINE, INC.**


**STATEMENTS
      OFOPERATIONS**


**(unaudited)**


**Three
                Months Ended**
            
            
            **Nine
                Months Ended****September
                30,**
              **2005**
            
            **September
                30,**
              **2004**
            
            
            **September
                30,**
              **2005**
            
            
            **September
                30,**
              **2004**REVENUES:Integration
                fees
            
            $
            203,542
            
            $
            75,152
            
            
            $
            585,262
            
            $
            268,902Syndication
                fees
            
            
            103,602
            
            
            50,630
            
            
            
            299,244
            
            
            111,872OEM
                revenues
            
            
            12,000
            
            
            13,750
            
            
            
            36,000
            
            
            42,186Web
                services
            
            
            24,686
            
            
            14,661
            
            
            
            65,576
            
            
            49,651Other
                revenues
            
            
            862
            
            
            839
            
            
            
            17,964
            
            
            2,969Related
                party revenues
            
            
            -
            
            
            82,513
            
            
            
            -
            
            
            247,538Total
                revenues
            
            
            344,692
            
            
            237,545
            
            
            
            1,004,046
            
            
            723,118COST
                OF REVENUES
            
            
            25,800
            
            
            58,823
            
            
            
            79,438
            
            
            159,250GROSS
                PROFIT
            
            
            318,892
            
            
            178,722
            
            
            
            924,608
            
            
            563,868OPERATING
                EXPENSES:General
                and administrative
            
            
            1,761,376
            
            
            964,614
            
            
            
            3,004,574
            
            
            2,007,121Sales
                and marketing
            
            
            374,841
            
            
            161,052
            
            
            
            957,519
            
            
            438,683Development
            
            
            371,137
            
            
            128,675
            
            
            
            872,767
            
            
            420,696Total
                operating expenses
            
            
            2,507,354
            
            
            1,254,341
            
            
            
            4,834,860
            
            
            2,866,500LOSS
                FROM OPERATIONS
            
            
            (2,188,462
            )
            
            (1,075,619
            )
            
            
            (3,910,252
            )
            
            (2,302,632
            )OTHER
                INCOME (EXPENSE):Interest
                income (expense), net
            
            
            7,606
            
            
            (7,404
            )
            
            
            17,801
            
            
            (122,001
            )Gain
                on debt forgiveness
            
            
            -
            
            
            -
            
            
            
            556,634
            
            
            49,395Total
                other income (expense)
            
            
            7,606
            
            
            (7,404
            )
            
            
            574,435
            
            
            (72,606
            )NET
                LOSS
            
            
            (2,180,856
            )
            
            (1,083,023
            )
            
            
            (3,335,817
            )
            
            (2,375,238
            )Preferred
                stock dividends and accretion of discount on preferred
                stock
            
            
            -
            
            
            -
            
            
            
            -
            
            
            (2,215,625
            )Accretive
                dividend issued in connection with registration rights
                agreement
            
            
            -
            
            
            (206,085
            )
            
            
            -
            
            
            (206,085
            )Converted
                preferred stock inducement cost
            
            
            -
            
            
            -
            
            
            
            -
            
            
            (3,225,410
            )Net
                loss attributed to common stockholders
            
            $
            (2,180,856
            )
            $
            (1,289,108
            )
            
            $
            (3,335,817
            )
            $
            (8,022,358
            )NET
                LOSS PER SHARE:Net
                loss attributed to
              common
                stockholders -
              Basic
                and Diluted
            
            $
            (0.17
            )
            $
            (0.12
            )
            
            $
            (0.27
            )
            $
            (0.72
            )SHARES
                USED IN COMPUTING NET LOSS PER SHARE
              Basic
                and Diluted
            
            
            12,832,365
            
            
            11,089,101
            
            
            
            12,353,443
            
            
            11,089,101





See
      notes
      to financial statements.





4
 Index


**SMART
      ONLINE, INC.**


**STATEMENTS
      OF CASH FLOWS**


**(unaudited)**




**Three
                Months Ended**
            
            **Nine
                Months Ended****September
                30,**
              **2005**
            
            **September
                30,**
              **2004**
            
            **September
                30,**
              **2005**
            
            **September
                30,**
              **2004**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                loss
            
            $
            (2,180,856
            )
            $
            (1,083,023
            )
            $
            (3,335,817
            )
            $
            (2,375,238
            )Adjustments
                to reconcile net loss to net cashused
                in operating activities:Depreciation
                and amortization
            
            
            14,989
            
            
            15,972
            
            
            39,237
            
            
            38,051Common
                shares, warrants, or options issued in lieu of
                compensation
            
            
            747,460
            
            
            6,035
            
            
            826,739
            
            
            167,035Common
                shares issued for extension of loan
            
            
            -
            
            
            -
            
            
            -
            
            
            75,000Common
                shares issued in exchange for warrants
            
            
            -
            
            
            350,000
            
            
            -
            
            
            350,000Issuance
                of warrants
            
            
            -
            
            
            -
            
            
            19,231
            
            
            -Gain
                on debt forgiveness
            
            
            -
            
            
            -
            
            
            (556,634
            )
            
            (49,395
            )Changes
                in assets and liabilities:Accounts
                receivable
            
            
            (19,200
            )
            
            30,110
            
            
            (19,002
            )
            
            59,380Related
                party receivable
            
            
            -
            
            
            -
            
            
            -
            
            
            38,682Other
                accounts receivable
            
            
            (19,623
            )
            
            (46,935
            )
            
            (24,622
            )
            
            (60,685
            )Prepaid
                expenses
            
            
            (256,942
            )
            
            8,557
            
            
            (486,832
            )
            
            (8,559
            )Legal
                settlement obligation
            
            
            -
            
            
            -
            
            
            -
            
            
            (181,563
            )Other
                assets
            
            
            -
            
            
            -
            
            
            44,888
            
            
            -Deferred
                revenue
            
            
            (169,757
            )
            
            109,314
            
            
            (359,967
            )
            
            (191,667
            )Accounts
                payable
            
            
            169,926
            
            
            107,388
            
            
            195,682
            
            
            (21,303
            )Accrued
                payroll
            
            
            55,475
            
            
            21,692
            
            
            105,484
            
            
            51,409Accrued
                payroll taxes payable
            
            
            4,341
            
            
            8,513
            
            
            (33,475
            )
            
            (956,993
            )Accrued
                interest payable
            
            
            -
            
            
            8,127
            
            
            -
            
            
            (126,871
            )Accrued
                expenses
            
            
            60,090
            
            
            -
            
            
            60,090
            
            
            -Deferred
                compensation, notes payable, and interest
            
            
            -
            
            
            (15,363
            )
            
            (1,091,814
            )
            
            60,980Net
                cash used in operating activities
            
            
            (1,594,097
            )
            
            (479,613
            )
            
            (4,616,812
            )
            
            (3,131,287
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchases
                of furniture and equipment
            
            
            (118,764
            )
            
            (56,530
            )
            
            (204,868
            )
            
            (81,438
            )Redemption
                of marketable securities
            
            
            -
            
            
            -
            
            
            395,000
            
            
            -Net
                cash provided by (used in) investing activities
            
            
            (118,764
            )
            
            (56,530
            )
            
            190,132
            
            
            (81,438
            )CASH
                FLOWS FROM FINANCING ACTIVITIES:Repayments
                on notes payable
            
            
            -
            
            
            -
            
            
            -
            
            
            (350,000
            )Repayments
                from stockholder
            
            
            -
            
            
            -
            
            
            -
            
            
            (86,480
            )Issuance
                of common stock
            
            
            5,119,754
            
            
            1,329,999
            
            
            8,212,641
            
            
            4,663,640Net
                cash provided by financing activities
            
            
            5,119,754
            
            
            1,329,999
            
            
            8,212,641
            
            
            4,227,160NET
                INCREASE IN CASH
              AND
                CASH EQUIVALENTS
            
            
            3,406,893
            
            
            793,856
            
            
            3,785,961
            
            
            1,014,035CASH
                AND CASH EQUIVALENTS,
              BEGINNING
                OF PERIOD
            
            
            552,407
            
            
            322,065
            
            
            173,339
            
            
            101,486CASH
                AND CASH EQUIVALENTS,
              END
                OF PERIOD
            
            $
            3,959,300
            
            $
            1,115,921
            
            $
            3,959,300
            
            $
            1,115,921


5
 Index





Supplemental
                disclosures:Cash
                payment during the period for interest:
            
            $
            -
            
            $
            -
            
            $
            154,288
            
            $
            164,055Non-cash
                financing activities:Non-cash
                accretion of preferred stock redemption value
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            2,215,625Conversion
                of preferred stock into common stock
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            19,724,839





See
      notes
      to financial statements.






























6
 Index


**Smart
      Online, Inc.**





**Notesto
      Financial Statements - Unaudited**





**1.**   **Summary
      of Business and Significant Accounting Policies**





***Basis
      of Presentation*** -The
      accompanying balance sheet as of September 30, 2005 and the statements of
      operations and cash flows for the three months and nine months ended September
      30, 2005 and 2004 are unaudited. These statements should be read in conjunction
      with the audited financial statements and related notes, together with
      management’s discussion and analysis of financial position and results of
      operations, contained in the Company’s Form 10-K for the year ended December 31,
      2004.





The
      financial statements have been prepared in accordance with accounting principles
      generally accepted in the United States, or U.S. GAAP. In the opinion of the
      Company’s management, the unaudited statements in the Form 10-Q include all
      adjustments necessary for the fair presentation of the Company’s statement of
      financial position as of September 30, 2005, its results of operations and
      its
      cash flows for the three months and nine months ended September 30, 2005 and
      2004. The results for the three months and nine months ended September 30,
      2005
      are not necessarily indicative of the results to be expected for the fiscal
      year
      ending December 31, 2005.





The
      accompanying financial statements have been prepared assuming that the Company
      will continue as a going concern. As such, they do not include adjustments
      relating to the recoverability of recorded asset amounts and classification
      of
      recorded assets and liabilities. The Company had accumulated losses of
      approximately $40 million at September 30, 2005 and will be required to make
      significant expenditures in connection with continuing development and marketing
      efforts along with general and administrative expenses. The Company’s ability to
      continue its operations is dependant upon its raising of capital through equity
      financing in order to meet its working capital needs.





These
      conditions raise substantial doubt about the Company’s ability to continue as a
      going concern, and, if substantial additional funding is not acquired or
      alternative sources developed, management will be required to curtail its
      operations.





The
      Company needs to raise additional capital by the sale of its equity securities
      or other financing avenues. Management believes that actions presently being
      taken to obtain additional funding provide the additional opportunity for the
      Company to continue as a going concern.





***Description
      of Business -*** Smart
      Online, Inc. (the “Company” or “Smart Online”) was incorporated in the State of
      Delaware in 1993. Smart Online develops and markets Internet-delivered
      Software-as-Service (SaS) software applications and data resources to start
      and
      grow small businesses (one to one hundred employees). Smart Online’s
      subscribers access Smart Online’s products through the portal at www.SmartOnline.com directly
      and through the web sites of private label syndication partners that include
      major companies and financial institutions.





***Fiscal
      Year -*** The
      fiscal year ends December 31. References to fiscal 2005, for example, refer
      to
      the fiscal year ending December 31, 2005.





***Use
      of Estimates -*** The
      preparation of financial statements in conformity with U.S. GAAP requires
      management to make estimates and assumptions in the Company’s financial
      statements and notes thereto. Significant estimates and assumptions made by
      management include the determination of the provision for income taxes, the
      fair
      market value of stock awards issued and the period over which revenue is
      generated. Actual results could differ from those estimates.





***Segments
      -*** The
      Company operates in one segment.





***Revenue
      Recognition*** -
      The
      Company recognizes revenue in accordance with accounting standards for software
      and service companies including United States Securities and Exchange Commission
      (“SEC”), Staff Accounting Bulletin No. 104, *Revenue
      Recognition* (“SAB
      104”), the Emerging Issues Task Force Issue No. 00-21, *Revenue
      Arrangements with Multiple Deliverables* (“EITF
      00-21”) *,* and
      related interpretations including American Institute of Certified Public
      Accountants (“AICPA”) Technical Practice Aids. We also utilize interpretative
      guidance from regulatory and accounting bodies, which include, but are not
      limited to, the SEC, the AICPA, the Financial Accounting Standards Board
      (“FASB”), and various professional organizations.





7
 Index


We
      recognize revenue when all of the following conditions are satisfied: (1) there
      is persuasive evidence of an arrangement; (2) the service has been provided
      to
      the customer; (3) the collection of our fees is probable; and (4) the amount
      of
      fees to be paid by the customer is fixed or determinable. EITF 00-21 states
      that
      revenue arrangements with multiple deliverables should be divided into separate
      units of accounting if the deliverables in the arrangement meet the following
      criteria: (1) the delivered item has value to the customer on a standalone
      basis; (2) there is objective and reliable evidence of the fair value of the
      undelivered item; and (3) if the arrangement includes a general right of return
      relative to the delivered item, delivery or performance of the undelivered
      item
      is considered probable and substantially in control of the vendor. Smart
      Online’s syndication and integration agreements typically include multiple
      deliverables including the grant of a non-exclusive license to distribute,
      use
      and access the Smart Online platform, fees for the integration of content into
      the Smart Online platform, maintenance and hosting fees, documentation and
      training, and technical support and customer support fees. Smart Online cannot
      establish fair value of the individual revenue deliverables based on objective
      and reliable evidence because the Company does not have a long, consistent
      history of standard syndication and integration contractual arrangements, there
      have only been a few contracts that have continued past the initial contractual
      term, the Company does not have any contracts in which these elements have
      been
      sold as stand-alone items, and there is no third-party evidence of fair value
      for products or services that are interchangeable and comparable to Smart
      Online’s products and services. As such, Smart Online cannot allocate revenue to
      the individual deliverables and must record all revenues received as a single
      unit of accounting as further described below. Additionally, Smart Online has
      evaluated the timing and substantive nature of the performance obligations
      associated with the multiple deliverables noted above, including the
      determination that the remaining obligations are essential to the on-going
      usability and functionality of the delivered products, and determined that
      revenue should be recognized over the life of the contracts due to such factors
      as the length of time over which the remaining obligations will be performed,
      the complex nature of integrating and maintaining customer content with Smart
      Online’s platform, which services are unavailable from other vendors, and the
      timing of payment of a portion of the contract price such as monthly hosting
      payments.





Syndication
      fees consist primarily of fees charged to syndication partners to create and
      maintain a customized private-label site and ongoing support, maintenance and
      customer service. The syndication agreements typically include an advance fee
      and monthly hosting fees. We generally invoice our customers in annual or
      monthly installments and typical payment terms provide that our customers pay
      us
      within 30 days of invoice. Amounts that have been invoiced are recorded as
      accounts receivable and in deferred revenue and the revenue is recognized
      ratably over the specified lives of the contracts, commencing on the date the
      site goes on-line. In general, we collect our billings in advance of the service
      period. The hosting fees are typically billed on a monthly basis. Our contracts
      and support contracts are non-cancelable, though they typically provide for
      early termination upon a material breach by either party that is not cured
      in a
      timely manner. We continue to evaluate and adjust the length of these
      amortization periods as we gain more experience with implementation schedules
      and contract cancellations. Should the contract terminate earlier than its
      term
      then we recognize the remaining deferred revenue upon termination. At present,
      Smart Online has insufficient historical data to determine if the relationships
      with its existing customers will extend beyond the initial term with the
      customer continuing to benefit from the advance fee. If Smart Online determines
      that existing and/or future contracts are expected to extend beyond the initial
      term whereby the customer continues to benefit from the advance fee, Smart
      Online would extend the revenue recognition period accordingly to include the
      extended term. Based on that experience, it is possible that, in the future,
      the
      estimates of customer lives may change and, in such event, the period over
      which
      such syndication revenues are amortized would be adjusted. Any such change
      in
      specified contract lives would affect our future results of operations.
      Additionally, the syndication contracts typically include revenue sharing
      arrangements whereby syndication partners typically charge their customers
      a
      monthly fee to access the private-label site. In most cases, the syndication
      agreement provides for Smart Online to receive a percentage of these fees.
      Fees
      derived from such revenue sharing arrangements are recorded when earned. To
      date
      such revenue sharing fees have been negligible.





Integration
      fees consist primarily of fees charged to integration partners to integrate
      their products into the Smart Online syndication platform. Integrating
      third-party content and products has been a key component of Smart Online’s
      strategy to continuously expand and enhance the platform offered to its
      syndication partners and its own customer base. We generally invoice our
      customers in advance of the service period in annual or monthly installments
      and
      typical payment terms provide that our customers pay us within 30 days of
      invoice. Amounts that have been invoiced are recorded in accounts receivable
      and
      in deferred revenue and the revenue is recognized ratably over the specified
      lives of the contracts, commencing on the date the site goes on-line. We
      continue to evaluate and adjust the length of these amortization periods as
      we
      gain more experience with implementation schedules and contract cancellations.
      At present, Smart Online has insufficient historical data to determine if the
      relationship with its existing customers will extend beyond the initial term
      with the customer continuing to benefit from the advance fee. If Smart Online
      determines that existing and/or future contracts are expected to extend beyond
      the initial term whereby the customer continues to benefit from the advance
      fee,
      Smart Online would extend the revenue recognition period accordingly to include
      the extended term. Our contracts and support contracts are non-cancelable,
      though they provide for early termination upon a material breach by either
      party
      that is not cured in a timely manner. Should the contract terminate earlier
      than
      its term then we recognize the remaining deferred revenue upon termination.
      Based on that experience, it is possible that, in the future, the estimates
      of
      customer lives may change and, in such event, the period over which such
      syndication revenues are amortized would be adjusted. Any such change in
      specified contract lives would affect our future results of operations.
      Additionally, integration agreements typically include an upfront fee and a
      revenue sharing component. Fees derived from such revenue sharing arrangements
      are recorded when earned. To date such revenue sharing fees have been
      negligible.


8
 Index


Both
      syndication and integration fees are recognized on a monthly basis over the
      life
      of the contract, although a significant portion of the fee from integration
      is
      received upfront. We generally invoice our customers in annual or monthly
      installments and typical payment terms provide that our customers pay us within
      30 days of invoice. Amounts that have been invoiced are recorded as accounts
      receivable and in deferred revenue or revenue depending on whether the revenue
      recognition criteria have been met. In general, we collect our billings in
      advance of the service period. Online marketing, which consists of marketing
      services provided to our integration and syndication partners have in the past
      generated additional revenue. In addition, certain users have requested that
      Smart Online implement online marketing initiatives for them, such as promoting
      their products through Google or Overture Services. Online marketing has not
      been a material source of past income. We intend to seek an increase in the
      level of online marketing services in the future.




OEM
      revenues are recorded based on the greater of actual sales or contractual
      minimum guaranteed royalty payments. Smart Online records the minimum guaranteed
      royalties monthly and receives payment of the royalties on a quarterly basis,
      30
      days in arrears. To the extent actual royalties exceed the minimum guaranteed
      royalties, the excess is recorded in the quarter Smart Online receives
      notification of such additional royalties.




Web
      Services revenues are comprised of e-commerce sales directly to end-users,
      hosting and maintenance fees, e-commerce website design fees and online loan
      origination fees. E-commerce sales are made either on a subscription or a la
      carte basis. Subscription, which is access to most Smart Online offerings,
      is
      payable in advance on a monthly basis and is targeted at small companies or
      divisions of large companies. We will seek to grow our monthly subscription
      volume over the next 24 months as new versions of Smart Online’s platforms
      (OneBiz SM Platform) are released.





Additionally,
      Smart Online receives a portion of third-party sales of products and services
      through revenue sharing arrangements, which involves a split of realized
      revenues. Hosting and maintenance fees are charged for supporting and
      maintaining the private-label portal and providing customer and technical
      support directly to our syndication partner’s users and are recognized on a
      monthly basis. E-commerce website design fees which are charged for building
      and
      maintaining corporate websites or to add the capability for e-commerce
      transactions are recognized over the life of the project. We have discontinued
      our third-party arrangement for online web design. We expect to resume this
      service after a new partner is under contract. Online loan origination fees
      are
      charged to provide users online financing options by which Smart Online receives
      payments for loan or credit provided. We intend to become more aggressive about
      promoting this line item in the future.





Subscription
      revenue is recognized ratably over the subscription period (usually one year).
      Third-party premium products are shared with integration partners.





*Barter
      Transactions* -
      Barter
      revenue relates to syndication and integration services provided by Smart Online
      to business customers in exchange for advertising in the customers’ trade
      magazines and on their Web sites. Barter expenses reflect the expense offset
      to
      barter revenue. The amount of barter revenue and expense is recorded at the
      estimated fair value of the services received or the services provided,
      whichever is more objectively determinable, in the month the services and
      advertising are exchanged. Smart Online applies APB 29, *Accounting
      for Non-Monetary Transactions* ,
      the
      provisions of EITF 93-11, *Accounting
      for Barter Transactions Involving Barter Credits* and
      EITF
      99-13, *Accounting
      for Advertising Barter Transactions* ,
      and,
      accordingly, recognizes barter revenues only to the extent that Smart Online
      has
      similar cash transactions within a period not to exceed six months prior to
      the
      date of the barter transaction. To date, the amount of barter revenue to be
      recognized has been more objectively determinable based on integration and
      syndication services provided rather than based upon the value of advertising
      received. For revenue from integration and syndication services provided for
      cash to be considered similar to the integration and syndication services
      provided in barter transactions, the services rendered must have been in the
      same media and similar term as the barter transaction. Further, the quantity
      or
      volume of integration or syndication revenue received in a qualifying past
      cash
      transaction can only evidence the fair value of an equivalent quantity or volume
      of integration or syndication revenue received in subsequent barter
      transactions. In other words, a past cash transaction can only support the
      recognition of revenue on integration and syndication contracts transactions
      up
      to the dollar amount of the cash transactions. When the cash transaction has
      been used to support an equivalent quantity and dollar amount of barter revenue,
      that transaction cannot serve as evidence of fair value for any other barter
      transaction. Once the value of the barter revenue has been determined, Smart
      Online follows the same revenue recognition principals as it applies to cash
      transactions with unearned revenues being deferred as described more fully
      above. At the time the barter revenue is recorded, an offsetting pre-paid barter
      advertising asset is recorded on Smart Online’s balance sheet. This pre-paid
      barter advertising asset is amortized to expense as advertising services are
      received such as when an advertisement runs in a magazine. Where more than
      one
      deliverable exists, such as when the barter partner is to provide advertising
      in
      four issues of a magazine, the expense is recognized pro-rata as the advertising
      deliverable is provided. Barter revenues totaled $77,977 and $31,727 for the
      three months ended September 30, 2005 and 2004, respectively. Barter revenues
      totaled $346,119 and $40,060 for the nine months ended September 30, 2005 and
      2004, respectively.








9
 Index


***Cash
      and Cash Equivalents*** -
      All
      highly liquid investments with an original maturity of three months or less
      are
      considered to be cash equivalents.





***Marketable
      Securities*** -
      Management determines the appropriate classification of investments in
      marketable securities at the time of purchase in accordance with Statement
      of
      Financial Accounting Standards No. 115. *Accounting
      for Certain Investments in Debt and Equity Securities* and
      reevaluates such determination at each balance sheet date. Securities, which
      are
      classified as available for sale at December 31, 2004, are carried at fair
      value, with the unrealized gains and losses, net of tax, reported as a separate
      component of stockholders’ equity. Fair value is determined based on quoted
      market rates. There were no unrealized gains or losses at December 31, 2004.
      Realized gains and losses and declines in value judged to be
      other-than-temporary on securities available for sale are included as a
      component of interest income. The cost of securities sold is based on the
      specific-identification method. Interest on securities classified as available
      for sale is also included as a component of interest income.





***Software
      Development Costs***- SFAS No. 86, *Accounting for the Costs of
      Software to be Sold, Leased or Otherwise Marketed*, requires capitalization
      of certain software development costs subsequent to the establishment of
      technological feasibility. Based on the Company’s product development process,
      technological feasibility is established upon completion of a working model.
      During the third quarter of 2005, Smart Online acquired certain rights to an
      accounting software application that is currently being integrated with the
      Company’s OneBizSM Platform and Smart Online capitalized $110,000 of
      costs associated with the acquired software.  See Note 6.  Prior to
      the third quarter of 2005, Smart Online had not capitalized any direct or
      allocated overhead associated with the development of software products prior
      to
      general release. Prior to the acquisition of the acquired software, costs
      related to software development incurred between completion of the working
      model
      and the point at which the product is ready for general release have been
      insignificant.





***Impairment
      of Long Lived Assets*** -
      Long-lived assets and certain identifiable intangibles are reviewed for
      impairment whenever events or changes in circumstances indicate that the
      carrying amount of an asset may not be recoverable. Recoverability of assets
      to
      be held and used is measured by a comparison of the carrying amount of an asset
      to future net cash flows expected to be generated by the asset. If such assets
      are considered to be impaired, the impairment to be recognized is measured
      by
      the amount by which the carrying amount of the assets exceeds the fair value
      of
      the assets. Assets to be disposed of are reported at the lower of the carrying
      amount or fair value less costs to sell.





***Property
      and Equipment*** -
      Property and equipment are stated at cost and are depreciated over their
      estimated useful lives, using the straight-line method as follows:





Office
                equipment
            5
                yearsFurniture
                and fixtures
            7
                yearsComputer
                software
            3
                yearsComputer
                equipment
            3
                yearsAutomobiles
            5
                years





***Intangible
      Assets*** -
      Intangible assets consist primarily of trademarks and are being amortized over
      their estimated useful lives.





***Fair
      Values*** -
      The
      fair values of cash equivalents, accounts receivable, accounts payable, accrued
      liabilities, and notes payable approximate the carrying values due to the short
      period of time to maturity.





***Accretion
      of Redemption Value of Redeemable Preferred Stock*** -
      The
      Company accreted the redemption value of redeemable preferred stock ratably
      over
      the minimum period such stock was outstanding. In addition, accrued but unpaid
      dividends were recorded to increase the carrying value of the redeemable
      preferred stock to the redemption value at maturity.





***Advertising
      Costs*** -
      Smart
      Online expenses all advertising costs as they are incurred. The amount charged
      to expense during the three months ended September 30, 2005 and 2004 were
      $48,414 and $43,223, respectively. The amount charged to expense during the
      nine
      months ended September 30, 2005 and 2004 were $238,266 and $97,705,
      respectively. The 2004 period reflects a credit related to prior advertising
      activities. These advertising costs included $46,251 and $34,375 of barter
      advertising expense for the three months ended September 30, 2005 and 2004,
      respectively, and $227,501 and $75,625 for the nine-months ended September
      30,
      2005 and 2004, respectively.





***Net
      Loss per Share -*** Basic
      loss per share is computed using the weighted-average number of common shares
      outstanding during the periods. Diluted loss per share is computed using the
      weighted-average number of common and dilutive common equivalent shares
      outstanding during the periods. Common equivalent shares consist of redeemable
      preferred stock, stock options and warrants that are computed using the treasury
      stock method. The Company excluded shares issueable upon the exercise of
      redeemable preferred stock, stock options and warrants from the calculation
      of
      common equivalent shares as the impact was anti-dilutive.


10
 Index


***Stock-Based
      Compensation*** -
      Smart
      Online accounts for its stock-based compensation plans in accordance with the
      intrinsic value provisions of Accounting Principles Board Opinion (“APB”) No.
      25, *Accounting
      for Stock Issued to Employees* .
      Stock
      Options are generally granted at prices equal to the fair value of Smart
      Online’s common stock on the grant dates. Accordingly, Smart Online did not
      record any compensation expense in the accompanying financial statements for
      its
      stock-based compensation plans. Had compensation expense been recognized
      consistent with the fair value provisions of SFAS No. 123, *Accounting
      for Stock-Based Compensation* ,
      Smart
      Online’s net loss attributed to common stockholders and net loss attributed to
      common stockholders per share for the quarters ended September 30, 2005 and
      2004
      would have been changed to the pro forma amounts indicated below:





Three
                Months Ended
            
            Nine Months
                Ended**September
                30, 2005**
            
            **September
                30, 2004**
            
            **September
                30, 2005**
            
            **September
                30, 2004**Net
                  loss attributed to
              common
                stockholders:As
                reported
            
            $
            (2,180,856
            )
            $
            (1,289,108
            )
            $
            (3,335,817
            )
            $
            (8,022,358
            )Add:
                Compensation costrecorded
                at intrinsic value
            
            
            -
            
            
            -
            
            
            -
            
            
            161,000Less:
                Compensation cost usingthe
                fair value method
            
            
            (204,099
            )
            
            (38,766
            )
            
            (300,503
            )
            
            (421,249
            )Pro
                forma
            
            $
            (2,384,955
            )
            $
            (1,327,874
            )
            $
            (3,636,320
            )
            $
            (8,282,607
            )








**Three
                months ended**
            
            **Nine
                months ended****September
                30, 2005**
            
            **September
                30, 2004**
            
            **September
                30, 2005**
            
            **September
                30, 2004**Reported
                  net loss attributed to
                common
                  stockholders:Basic
                and diluted
            
            $
            (0.17
            )
            $
            (0.12
            )
            $
            (0.27
            )
            $
            (0.72
            )Pro
                forma net loss per share:Basic
                and diluted
            
            $
            (0.19
            )
            $
            (0.12
            )
            $
            (0.29
            )
            $
            (0.75
            )





The
      fair
      value of option grants under Smart Online’s plan and other stock option
      issuances during the quarter and nine months ended September 30, 2005 and 2004
      were estimated using the Black-Scholes option-pricing model with the following
      weighted-average assumptions:





**Three
                Months Ended**
            
            **Nine
                Months Ended****September
                30,**
              **2005**
            
            **September
                30,**
              **2004**
            
            **September
                30,**
              **2005**
            
            **September
                30,**
              **2004**Dividend
                yield
            
            
            0.
                00
            %
            
            0.
                00
            %
            
            0.
                00
            %
            
            0.
                00
            %Expected
                volatility
            
            
            15.6
            %
            
            0.00
            %
            
            20.5
            %
            
            0.00
            %Risk
                free interest rate
            
            
            4.23
            %
            
            4.23
            %
            
            4.23
            %
            
            4.31
            %Expected
                lives (years)
            
            
            9.7
            
            
            5.0
            
            
            9.5
            
            
            5.0





***New
      Accounting Standards***





In
      December 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-Based
      Payment* (“SFAS
      123(R)”). SFAS 123(R), a revision of SFAS 123, *Accounting
      for Stock-Based Compensation* ,
      which
      supersedes APB Opinion No. 25, *Accounting
      for Stock Issued to Employees* ,
      and
      amends SFAS No. 95, *Statement
      of Cash Flows* .
      SFAS
      123(R) requires all share-based payments to employees, including grants of
      employee stock options, to be recognized in the financial statements based
      on
      their fair values. SFAS 123(R) is effective for the beginning of the annual
      period beginning after June 15, 2005. Therefore the Company plans to adopt
      SFAS
      123(R) on January 1, 2006. The Company is currently assessing the impact of
      this
      prospective change in accounting and believes that it will have a material
      and
      adverse impact on the Company’s reported results of operations.


11
 Index





**2.
      Balance Sheets Accounts**





***Marketable
      Securities***





As
      of
      December 31, 2004, marketable securities consisted of the
      following:





**Amortized**
              **Cost**
            
            **Fair
                Value**Municipal
                bonds - redeemed February 2005
            
            $
            395,000
            
            $
            395,000





Smart
      Online did not hold any marketable securities as of September 30,
      2005.





***Receivables***





Smart
      Online evaluates the need for an allowance for doubtful accounts based on
      specifically identified amounts that management believes to be uncollectible.
      Management also records an additional allowance based on certain percentages
      of
      its receivables over 90 days old, which are determined based on historical
      experience and management’s assessment of the general financial conditions
      affecting its customer base. If actual collections experience changes, revisions
      to the allowance may be required. Based upon the aforementioned criteria,
      management has determined that no provision for uncollectible accounts is
      required as of September 30, 2005 and December 31, 2004.





***Property
      and Equipment***





Property
      and equipment consists of the following at:





**September
                30,**
              **2005**
            
            **December
                31,**
              **2004**Office
                equipment
            
            $
            32,580
            
            $
            16,187Furniture
                and fixtures
            
            
            7,125
            
            
            7,125Computer
                software
            
            
            423,600
            
            
            393,629Computer
                equipment
            
            
            733,248
            
            
            663,723Automobiles
            
            
            29,504
            
            
            29,5041,226,057
            
            
            1,110,168Less
                accumulated depreciation
            
            
            (1,070,533
            )
            
            (1,034,532
            )Property
                and equipment, net
            
            $
            155,524
            
            $
            75,636





Depreciation
      expense for the three months ended September 30, 2005 and 2004 was $13,910
      and
      $14,939, respectively. Depreciation expense for the nine months ended September
      30, 2005 and 2004 was $36,001 and $34,954, respectively.





***Deferred
      Compensation***





Certain
      officers of Smart Online deferred a portion of their compensation, including
      commissions and interest charges on previously earned but unpaid compensation,
      from the second quarter of 2001 until September, 2003. In October 2003, these
      salary deferrals plus interest were converted to promissory notes (the “2003
      Notes”) in the aggregate amount of $1,049,765. These notes were payable on or
      before May 31, 2004 and bore interest at a rate of 15% per annum. During the
      fourth quarter of 2003 and the first quarter of 2004, these officers deferred
      an
      additional $141,771. Additionally, during this period $50,135 of the original
      notes payable were repaid. In April 2004, the holders of the 2003 Notes agreed
      to exchange the existing notes for new promissory notes payable on or before
      December 31, 2005. The principal amount of the new notes, $1,141,401, included
      the unpaid principal from the original notes plus the subsequent deferrals.
      Subsequently during 2004, $160,904 was repaid against the successor notes and
      an
      additional $2,302 of compensation was deferred. The successor notes bore
      interest at a rate of 15% per annum through June 1, 2004 at which time the
      holders voluntarily reduced the rate to 8% per annum. On April 30, 2004, the
      2004 Notes were extended until May 31, 2005, but later during 2004 the officers
      entered into standstill agreements not to demand payment until June 30, 2006.
      The standstill agreement was again amended on December 22, 2004, to provide
      that
      demand for payment could be made upon the earlier of June 30, 2006 or the
      closing after January 1, 2005 of a financing with gross proceeds to Smart Online
      of $2,000,000 or more. After Smart Online raised $2,500,000 from a sale of
      securities to a foreign investor in February 2005, Smart Online paid in full
      the
      $949,777 of deferred compensation, plus all accrued interest of $154,288, and
      cancelled the related promissory notes to these officers.


12
 Index


**3.
      Stockholders’ Equity (Deficit)**





Sale
      of Common Stock





During
      February and March 2005, Smart Online sold 500,000 and 80,000 shares of Common
      Stock, respectively, to foreign investors in sales exempt under Regulation
      S.
      The February and March 2005 stock sales resulted in gross proceeds of $2,500,000
      and $400,000 (unaudited), respectively. A portion of those funds were used
      to
      repay deferred compensation, including interest thereon, as more fully discussed
      in Note 6. In connection with this financing, Smart Online incurred stock
      issuance costs of $290,000 to an entity that is an existing shareholder.
      Concurrent with the sale of Common Stock, Smart Online issued warrants to
      purchase 50,000 shares of Common Stock to this investor in consideration for
      the
      investor agreeing to certain restrictions on their ability to sell the shares.
      These warrants have an exercise price of $5 per share and terminate on January
      1, 2007. During February 2005, Smart Online raised an additional $125,000 in
      gross proceeds from the sale of 25,000 shares of Common Stock at $5.00 per
      share
      in a private placement.





During
      July 2005, Smart Online sold 90,909 shares of its Common Stock to an existing
      investor for a price of $5.50 per share resulting in gross proceeds of $500,000.
      Also during July 2005, Smart Online sold an additional 36,363 shares to a new
      investor resulting in gross proceeds of $199,997. In connection with this
      financing, Smart Online incurred stock issuance costs of $70,000 to an entity
      introduced to Smart Online by an existing shareholder, Doron Roethler.
      Additionally, in connection with these offerings, Smart Online entered into
      Registration Rights Agreements with these shareholders under which Smart Online
      is required to file a registration statement with the SEC to register the shares
      sold in the offering no later than September 30, 2005.





During
      August and September 2005, Smart Online sold 786,642 shares of its Common Stock
      to a new and existing investors for a price of $5.50 per share resulting in
      gross proceeds of $4,326,531. In connection with this financing, the Smart
      Online incurred stock issuance costs of $270,525 to an entity introduced to
      Smart Online by an existing shareholder, Doron Roethler. Additionally, in
      connection with these offerings, Smart Online entered into Registration Rights
      Agreements with these shareholders under which Smart Online is required to
      file
      a registration statement with the SEC to register the shares sold in the
      offering no later than September 30, 2005.





Exercise
      of Warrants





During
      February 2005, a consulting firm that was issued 350,000 warrants in November
      2003 acquired 50,000 shares of Smart Online’s Common Stock as a result of the
      cashless exercise of warrants. Warrants to purchase 67,568 shares of Common
      Stock were cancelled in this cashless exercise. The fair market value of Smart
      Online’s Common Stock at the time of exercise was $5.00. During May 2005, this
      same consulting firm acquired 48,617 shares of Smart Online’s Common Stock as a
      result of the cashless exercise of warrants. Warrants to purchase 62,432 shares
      of Common Stock were cancelled in this cashless exercise. The fair market value
      of Smart Online’s Common Stock at the time of exercise was $5.875. At September
      30, 2005, 27,000 of the warrants issued in November 2003 were still outstanding.




During
      the third quarter of 2005, holders of warrants to purchase 355,428 shares of
      Common Stock exercised their warrants resulting in gross proceeds to Smart
      Online of $1,175,998. The warrants had exercise prices that ranged from $1.30
      to
      $5.00 per share.





Employee
      Stock Bonus





During
      the third quarter, Smart Online paid a bonus of 4,200 shares of its Common
      Stock
      to non-officer employees. Smart Online recorded approximately $40,000 of
      compensation expense during the third quarter related to this bonus
      payment.  The expense associated with the stock bonus was calculated based
      upon the fair market value of the Common Stock on the date the bonus was
      awarded.





***Stock
      Option Plans***





Smart
      Online maintains three equity compensation plans.





The
      following is a summary of the status of the plan and stock option
      activity:


13
 Index








**Shares**
            
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**BALANCE,
                December 31, 2004
            
            
            1,768,900
            
            $
            2.78Granted
            
            
            1,307,750
            
            
            8.08Exercised
            
            
            (16,500
            )
            
            3.50Forfeited
            
            
            (560,400
            )
            $
            3.61BALANCE,
                September 30, 2005
            
            
            2,499,750
            
            $
            5.34





The
      following table summarizes information about stock options outstanding as of
      September 30, 2005:





**Currently
                Exercisable****Exercise**
              **Price**
            **Number
                of**
              **Shares**
              **Outstanding**
            **Average**
              **Remaining**
              **Contractual
                Life**
              **(Years)**
            **Weighted**
              **Average
                Exercise**
              **Price**
            **Number
                of**
              **Shares**
            **Weighted**
              **Average**
              **Exercise**
              **Price**$
                1.30 - $ 1.43
            670,000
            3.3
            $
                1.40
            670,000
            $
                1.40$
                3.50
            497,500
            8.6
            $
                3.50
            203,210
            $
                3.50$
                5.00
            285,500
            9.1
            $
                5.00
            34,500
            $
                5.00$
                7.00
            48,000
            9.7
            $
                7.00
            -
            -$
                8.61
            737,250
            9.8
            $8.61
            5,000
            $8.61$
                9.60 - $ 9.82
            261,500
            10.0
            $9.82
            -
            -$
                1.30 - $ 9.82
            2,499,750
            7.7
            $5.34
            912,710
            $
                2.04





***Dividends***





Smart
      Online has not paid any cash dividends through September 30, 2005.





**4.
      Major Customers and Concentration of Credit Risk**





Smart
      Online derives a significant portion of its revenues from certain customer
      relationships. The following is a summary of customers that represent greater
      than ten percent of total revenues:





3
                Months Ended September 30, 2005Revenues
            
            %
                of Total
              RevenuesCustomer
                A
            
            
            Integration
            
            $
            85,000
            
            
            24.7
            %Customer
                B
            
            
            Integration
            
            
            50,000
            
            
            14.5
            %Customer
                C
            
            
            Syndication/Barter
            
            
            46,250
            
            
            13.4
            %Others
            
            
            Various
            
            
            163,442
            
            
            47.4
            %Total
            
            
            
            
            $
            344,692
            
            
            100.0
            %





3
                Months Ended September 30, 2004Revenues
            
            %
                of Total
              RevenuesCustomer
                E
            
            
            Integration
            
            $
            82,513
            
            
            34.7
            %Customer
                F
            
            
            Integration/Barter
            
            
            26,727
            
            
            11.3
            %Customer
                G
            
            
            Integration
            
            
            25,000
            
            
            10.5
            %Others
            
            
            Various
            
            
            103,305
            
            
            43.5
            %Total
            
            
            
            
            $
            237,545
            
            
            100.0
            %





14
 Index





9
                Months Ended September 30, 2005Revenues
            
            %
                of Total
              RevenuesCustomer
                A
            
            
            Integration
            
            $
            136,183
            
            
            13.6
            %Customer
                B
            
            
            Integration
            
            
            125,000
            
            
            12.4
            %Customer
                C
            
            
            Syndication/Barter
            
            
            127,188
            
            
            12.7
            %Customer
                D
            
            
            Integration/Barter
            
            
            123,750
            
            
            12.3
            %Others
            
            
            Various
            
            
            491,925
            
            
            49.0
            %Total
            
            
            
            
            $
            1,004,046
            
            
            100.0
            %





9
                Months Ended September 30, 2004Revenues
            
            %
                of Total
              RevenuesCustomer
                E
            
            
            Integration
            
            $
            247,538
            
            
            34.2
            %Others
            
            
            Various
            
            
            475,580
            
            
            65.8
            %Total
            
            
            
            
            $
            723,118
            
            
            100.0
            %





As
      of
      September 30, 2005, three of Smart Online's customers accounted for 46.7%,
      43.1%, and 10.0% of accounts receivable. One of these customers accounted for
      substantially all of the accounts receivable at December 31, 2004.





**5.**  **Related
      Party Transactions**





American
      Investment Holding Group, Inc., which is wholly-owned by two officers of Smart
      Online, owns approximately 23% of the outstanding Common Stock of Smart Online
      as of September 30, 2005. The same officers also own a controlling interest
      in
      other companies, some of which companies own Smart Online Common
      Stock.





An
      officer of Smart Online and a trust established by this officer for the benefit
      of his children have from time to time provided loans to Smart Online. As of
      January 1, 2004, Smart Online owed these parties $47,798 related to outstanding
      loans. During the first six months of 2004, the Company borrowed an additional
      $186,335 and repaid the entire remaining outstanding balance of $186,335. As
      of
      September 30, 2004 all borrowings from and loans to the officer and the trust
      were repaid in full. Until October 2003, the Company did not pay any interest
      on
      these loans, thereafter the loans accrued interest at a rate of
      15.0%.





During
      2004 and 2005, Smart Online contracted with a consulting firm owned by an
      individual who was an officer of the Company at the time to provide strategic
      international sales and marketing services. Smart Online paid consulting fees
      of
      $17,500 during both the first quarter of 2005 and 2004 related to these
      services. Additionally, Smart Online paid the same consulting firm $2,500
      related to the sale of certain shares of Common Stock during the first quarter
      of 2004. This consulting agreement was terminated in March, 2005.





On
      August
      13, 2002, Smart Online entered into an integration agreement with SIL, a company
      owned by a shareholder of Smart Online, to incorporate its products into Smart
      Online’s platform. As part of this agreement, SIL paid Smart Online $300,000 for
      such integration, and the parties agreed to share future revenues generated
      from
      the sales of the products. On August 30, 2002, the parties signed an amendment
      to the original agreement, in order for Smart Online to provide SIL certain
      co-development services, which includes instant messenger and video
      conferencing. In exchange, SIL paid Smart Online an additional sum of $300,000.
      The parties further agreed that the products developed as a result of both
      companies’ efforts will be owned by both parties. On April 30, 2003, Smart
      Online and SIL signed a new amendment and restated the integration program
      agreement. According to this new amendment and restated agreement, Smart Online
      agreed to fund the future development of the products. In exchange, SIL agreed
      to limit future amounts payable by Smart Online under the original shared
      revenue agreement to $1.7 million.





In
      addition to the above agreements, on August 30, 2002, Smart Online and SIL
      also
      entered into a reseller agreement whereby SIL paid the sum of $200,000 for
      the
      right to distribute Smart Online’s products in the territories of Israel, the
      United Kingdom, France, Italy, the Netherlands, and Spain, in exchange for
      Smart
      Online’s marketing support and a twenty percent commission from the gross sales
      generated by SIL. On March 17 and 27, 2003, the parties subsequently modified
      the original re-seller agreement to restrict the territory to only Israel and
      the Netherlands. Additionally, on December 22, 2003, Smart Online signed a
      private label syndication agreement with SIL to provide website development
      for
      SIL’s website.


15
 Index





Smart
      Online also paid SIL $90,000 pursuant to their contract dated December 20,
      2003
      for technical co-development work on a monthly payment of $15,000 starting
      in
      December of 2003 and ending in May of 2004.





In
      March
      2004, SIL ceased further development of its technology and laid-off its
      employees. SIL is currently seeking opportunities to license or sell its
      technology. The Company continues to support this technology on behalf of SIL.
      The revenues derived from this agreement with SIL were recognized as income
      on a
      straight line basis over the life of the agreement. Smart Online recognized
      $330,050 of revenue related to the aforementioned integration, co-development
      and reseller agreements during 2004.





During
      the first half of 2004, Smart Online paid $158,384 to the Small Business Lending
      Institute (SBLI), of which an officer of Smart Online is also an officer and
      in
      which another officer of Smart Online is a minority shareholder, because SBLI
      paid Smart Online’s employees during the first quarter of 2004 while Smart
      Online was dealing with a tax matter with the Internal Revenue
      Service.





The
      following is a summary of related party revenues for the three months and nine
      months ended September 30, 2005 and 2004:








Three
                Months Ended
            
            Nine Months
                EndedSeptember 30,
                2005
            
            September
                30, 2004
            
            September
                30, 2005
            
            September
                30, 2004Smart
                II, Ltd. ("SIL"), formerly
              known
                as Smart Revenue Europe Ltd.- Integration fees
            
            $
            -
            
            $
            82,513
            
            $
            -
            
            $
            247,538Total
                Related Party Revenues
            
            $
            -
            
            $
            82,513
            
            $
            -
            
            $
            247,538





The
      following is a summary of related party expenses for the three months and nine
      months ended September 30, 2005 and 2004:





Three
                Months Ended
            
            Nine
                Months EndedSeptember
                30, 2005
            
            September
                30, 2004
            
            September
                30, 2005
            
            September
                30, 2004Nen,
                Inc. - consulting fees included
              in
                sales and marketing expense
              related
                to strategic international sales and marketing services
            
            $
            -
            
            $
            17,500
            
            $
            17,500
            
            $
            52,500Nen,
                Inc. - consulting fees included
              in
                general and administrative
              expense
                related to assisting Smart
              Online
                with obtaining additional
              equity
                financing
            
            
            -
            
            
            -
            
            
            -
            
            
            31,000Small
                Business Loan Institute -
              consulting
                fees included in general
              and
                administrative expense
            
            
            -
            
            
            -
            
            
            -
            
            
            30,000Smart
                II, Ltd. - Moving expenses,
              reseller
                payment, and technical co-
              development
                work
            
            
            -
            
            
            -
            
            
            -
            
            
            75,000Interest
                expense incurred on
              loans
                from officer
            
            
            -
            
            
            -
            
            
            -
            
            
            4,649Total
                Related Party Revenues
            
            $
            -
            
            $
            77,526
            
            $
            17,500
            
            $
            193,149





16
 Index





**6.
      Commitments and Contingencies**





Smart
      Online is subject to claims and suits that arise from time to time in the
      ordinary course of business.




As
      discussed in Note 1, in August 2005, Smart Online
      entered into a software assignment and development agreement with the developer
      of a customized accounting software application.  In connection with this
      agreement, Smart Online agreed to pay the developer up to $512,500 and issue
      up
      to $287,500 worth of Smart Online Common Stock based upon the developer
      attaining certain milestones.  As of September 30, 2005, Smart Online had
      paid $90,000 and issued $15,000 worth of Common Stock related to this
      obligation.


On
        or
        about November 10, 2005, the Smart Online instituted a law suit in the General
        Court of Justice Superior Court Division in Wake County, North Carolina against
        X.C.L. Partners, Inc. (“XCL”) seeking a declaratory judgment determining that
        Smart Online did not enter into a contract with XCL and therefore has no
        contractual relationship with XCL. Smart Online filed such law suit in response
        to a letter dated November 3, 2005 from XCL’s attorneys alleging that the
        Company is in breach of a contract with XCL and demanding, at a minimum,
        $200,000 plus 121,667 shares of stock of Smart Online. Management has determined
        with the advice of legal counsel that the claim has no merit.
 
 Approximately
        three and a half years ago, Smart Online petitioned (as is required under
        French
        law) a court in France to allow Smart Online to liquidate Smart Online S.A.,
        a
        French subsidiary of Smart Online. As a result, Smart Online paid $113,057
        to
        Smart Online S.A. in settlement of all claims against Smart Online. Recently,
        Michael Nouri, the President and CEO of the Smart Online and the former
        President and CEO of Smart Online S.A., was sued personally as the legal
        representative of Smart Online S.A., which suit alleges that Smart Online
        S.A.
        suffered unspecified amounts of excess liabilities and seeks to hold Mr.
        Nouri
        personally responsible. The Liquidateur for Smart Online, S.A. has agreed
        to a
        proposal for settlement offered by Mr. Nouri in the amount of $15,000 Euros
        (approximately USD $18,750 based on an exchange rate of $1.27 USD per Euro).
        This agreement is subject to approval by the French court. There can be no
        assurance this agreement will result in a final settlement on these terms.
        The
        Board of Directors of Smart Online has authorized Smart Online to indemnify
        Mr.
        Nouri for the amount of any settlement and all legal costs and fees associated
        with the defense of Mr. Nouri in relation to this matter, because Mr.Nouri
        was
        acting on behalf of Smart Online in the liquidation of its French subsidiary.




**7.
      Subsequent Events**





**Computility
      Acquisition**





On
      October 4, 2005, Smart Online completed its acquisition of substantially all
      of
      the assets of Computility, Inc., (“Computility”) a Iowa based company providing
      web-based software, and other information software and hardware and services,
      primarily to small business customers, pursuant to an Asset Purchase Agreement
      dated as of October 4, 2005 by and among Smart Online, Smart CRM, Inc.,
      Computility and certain shareholders of Computility. The acquired assets include
      all of the fixed assets, machinery, equipment, fixtures, leasehold improvements,
      furniture, intellectual property, leases, accounts receivable, factoring
      contracts and goodwill.





In
      consideration for the purchased assets, Smart Online issued the seller 484,213
      shares of Smart Online C ommon
      Stock (valued at approximately $3.5 million based upon the fair market value
      of
      Smart Online's stock at the closing date) and assumed certain liabilities of
      Computility totaling approximately $1.9 million.  In addition two key
      employees of Computility can earn up to $91,800 each over and above their base
      compensation during the fifteen months ended December 31, 2006, if certain
      performance agreements which typically have 3-year terms with substantial
      penalties for early termination.  Until the date of the acquisition,
      Computility factored substantially all of its subscription agreements and
      received approximately 65% of the expected cashflow from the subscription period
      upfront and use the cash to fund on-going operations.  As a result of the
      factoring arrangements, Smart Online will be required to provide services to
      the
      customers, but will only receive approximately 35% of the corresponding customer
      payments.  Additionally, as a result of this factoring activity and based
      on contracts signed as of the date of acquisition, management expects that
      the
      acquisition will result in an approximate $100,000 monthly increase in cash
      expenditures for the remainder of 2005.




Smart
        Online and Smart CRM entered into employment agreements with two key employees
        and shareholders of Computility. One of these individuals serves as Director
        CRM
        Business Development to Smart CRM, receiving an annual salary of $90,000,
        $45,000 in consideration of a non-compete covenant and a bonus of up to $91,800
        to be earned upon achievement of certain revenue milestones set forth in
        the
        employment agreement during the period from the date of the acquisition through
        March 31, 2007. One of the individuals serves as Director CRM Technology
        to
        Smart CRM, receiving an annual salary of $90,000, $45,000 in consideration
        of a
        noncompetion covenant and a bonus of up to $91,800 to be earned upon achievement
        of certain software development milestones set forth in the employment agreement
        during the period from the date of the acquisition through March 31,
        2007.





**iMart
      Incorporated Acquisition**





On
      October 18, 2005, Smart Online completed its purchase of all of the capital
      stock of iMart Incorporated (“iMart”), a Michigan based company providing
      multi-channel electronic commerce systems, pursuant to a Stock Purchase
      Agreement, dated as of October 17, 2005 by and among Smart Online, iMart and
      the
      shareholders of iMart.





Several
      provisions of the iMart acquisition agreements restrict Smart Online’s ability
      to utilize the revenue from iMart’s business after the acquisition. These
      provisions include a lock box arrangement to secure the acquisition purchase
      price installment payment obligations of Smart Online described below and
      restrictions on transfers of cash from iMart to Smart Online until payment
      of
      obligations due through January 2007. The acquisition agreements also give
      a key
      employee of iMart before the acquisition, contractual rights and
      obligations to operate the business of iMart after the acquisition
      within agreed performance parameters. All of these provisions, which are
      summarized below, are interrelated.





Acquisition
      Payments





Smart
      Online has agreed to pay the following to the former shareholders of
      iMart:





(i)
      205,767 shares of Smart Online Common Stock were issued to the former
      shareholders at the Closing (these shares were valued at approximately $1.8
      million based upon the fair market value of Smart Online's Common Stock on
      the
      closing date); and





(ii)  
      $3,366,000 in cash is payable in installments as follows: (a) four equal
      installments of $420,750 are required to be paid on each of January 2, 2006,
      April 3, 2006, July 5, 2006 and October 2, 2006 and (b) $1,683,000 is required
      to be paid on January 5, 2007; however, this last acquisition purchase price
      installment payment must be pre-paid if iMart’s business meets certain economic
      milestones described below.




**Amendment
      to Form 10-Q for Quarter Ended June
      30, 2005**




Smart
      Online has determined that it incorrectly
      applied certain provisions of Emerging Issuer Task Force (EITF) 00-19,
*Accounting For Derivative Financial Instruments Indexed to, and Potentially
      Settled in, a Company's Own Stock*.  Specifically, Smart Online
      incorrectly recorded $506,000 of general and administrative expense during
      the
      second quarter of 2005 related to a mark to market adjustment of certain
      warrants.  Since these warrants were part of permanent equity, Smart Online
      should not have applied the mark to market provisions of EITF 00-19. 
Accordingly, the net loss for the quarter ended June 30, 2005 has been reduced
      by $506,000 and Smart Online will be filing an amended Form 10-Q for the quarter
      ended June 30, 2005 to reflect the reduction in net loss.






17
 Index





If
      iMart
      collects more than $130,000 of specified account receivables during the period
      after October 17, 2005 through November 15, 2005, the cash purchase price will
      be increased dollar for dollar by the amount of the excess up to a maximum
      of
      $139,500 of additional purchase price. Half the increase is payable on January
      5, 2007 and the remainder is payable in four equal installments on January
      2,
      2006, April 3, 2006, July 5, 2006, and October 2, 2006.





Employment
      and Noncompetition and Software License





iMart
      and
      Smart Online entered into employment agreements with two key employees, pursuant
      to which they will receive annual salaries aggregating $250,000. In addition,
      an
      aggregate of $780,000 will be paid to them for their covenants not to compete
      with iMart or Smart Online.





If
      iMart
      or Smart Online fail to pay the $3,366,000 purchase price installments or the
      $780,000 of non-competition payments described above when they become due,
      the
      non-competition covenants of the key employees will terminate, their
      nonsolicitation and nondisclosure covenants will become more limited in scope,
      and one of the key employees will have a nonexclusive royalty-free license
      to
      certain iMart software for 18 months.




**Lock
      Box Agreement**




The
      cash
      payments described above are secured by the net proceeds of customer contracts
      of iMart, which will limit Smart Online’s ability to use iMart revenue in its
      business until all cash is paid to iMart shareholders and employees, as all
      iMart revenue will be deposited in a lock box account which is to be used to
      pay
      the operating expenses of iMart and the acquisition installment payment and
      non-competition payment obligations of Smart Online. The lock box account is
      to
      be terminated when all of the acquisition purchase price installment payments
      have been made, provided that all non-competition payments due through January
      5, 2007 have also been made. The security interest is limited to the $3,366,000
      of acquisition purchase price installment payments described above.





The
      agreements provide that money in the lock-box account will be utilized to pay
      approximately $146,000 of the monthly operating expenses of the iMart subsidiary
      of Smart Online, the $3,366,000 of acquisition purchase price installment
      payments, and up to $780,000 of the non-competition payment obligations of
      Smart
      Online described above. The agreements do not specify a priority of use of
      one
      of the specified uses over any other specified uses. Consequently, the release
      of money from the lock box account will depend on agreement by the persons
      authorized to disburse funds. In this regard, the agreements provide that money
      cannot be withdrawn from the lock box account without the agreement of both
      (i)
      a person designated by iMart’s selling shareholders, and (ii) either Michael
      Nouri, the Chief Executive Officer of Smart Online, Scott Whitaker, the Chief
      Financial Officer of Smart Online, or some other person designated by Smart
      Online. The parties have agreed to not unreasonably withhold authorization
      to
      withdraw funds.





Lock
      box
      deposits cannot be transferred from iMart to Smart Online or any other
      subsidiary of Smart Online unless after the transfer the balance in the lock
      box
      account is $500,000 or more. The excess on deposit in the lock box account
      can
      be transferred to Smart Online, less the amount of the increase, if any, in
      the
      deferred revenue of iMart compared to iMart’s deferred revenue at the time the
      acquisition closed. If iMart’s revenues for any fiscal quarter exceed $900,000,
      50% of any lock box excess (after taking into account deferred revenue as
      described above) at the end of the fiscal quarter must be used to prepay the
      $1,683,000 installment payment of the acquisition purchase price that is due
      in
      January 2007, and 50% of the lock box excess can be transferred to Smart
      Online.





**Contractual
      Decision-Making Powers of Key Employee**





The
      acquisition agreements also provide that a key employee of iMart will have
      contractual rights to conduct the operations of iMart. These contractual rights
      are outside the scope of normal corporate governance rules. These contractual
      decision-making powers allow the key employee to operate iMart’s business and to
      make payments from the lock box account for such operating expenses, the
      purchase price installment payments and the non-competition payments, subject
      to
      the signature of a Smart Online designee as described above. These contractual
      decision-making powers do not extend to any financial payments or obligations
      greater than $20,000, capital investments or transactions outside of the
      ordinary course of business, customer contracts with greater than $50,000 of
      revenue or commitments for iMart to provide services for more than six
      months.





These
      contractual decision-making powers of the key employee are to continue as long
      as the monthly cost of operations of iMart do not exceed approximately $146,000,
      and the earnings before interest, taxes, depreciation, amortization (EBITDA)
      of
      iMart’s operations exceed $1,452,795 and other financial parameters for iMart
      remain substantially similar to or better than the equivalent numbers for iMart
      during 2004. This provision does not terminate when all the acquisition purchase
      price installment payments and non-competition payments are made, and could
      continue perpetually if the financial performance parameters continue to be
      met.


18
 Index


**Investor
      Relations Agreements**





In
        October 2005 Smart Online entered into agreements with two foreign firms
        to
        provide investor relations services. In connection with these agreements,
        Smart
        Online paid each of the investor relations firms $250,000 and issued
        each of the firms 625,000 shares of our Common Stock. In addition to
        recording the $500,000 of investor relations expenses for the cash portion
        of
        the investor relations fee, we expect to incur non-cash expenses equal to
        the
        fair market value of the shares.


**Item
      2. MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
      AND RESULTS OF OPERATIONS (including Risk Factors)**





*The
      following discussion in Management’s Discussion and Analysis of Financial
      Condition as Results of Operations (“MD&A”) and elsewhere in this report
      contains forward-looking statements within the meaning of Section 27A of the
      Securities Act of 1933 and Section 12E of the Securities Exchange Act of 1934.
      Forward-looking statements consist of, among other things, trend analyses,
      statements regarding future events, future financial performance, our plan
      to
      build our business and the related expenses, our anticipated growth, trends
      in
      our business, the effect of foreign currency exchange rate and interest rate
      fluctuations on our business, the potential impact of current litigation or
      any
      future litigation, the potential availability of tax assets in the future and
      related matters, and the sufficiency of our capital resources, all of which
      are
      based on current expectations, estimates, and forecasts, and the beliefs and
      assumptions of our management. Words such as “expects,“
“anticipates,”“projects,”“intends,”“plans,”“estimates,” variations of such
      words, and similar expressions are also intended to identify such
      forward-looking statements. These forward-looking statements are subject to
      risks, uncertainties and assumptions that are difficult to predict. Therefore,
      actual results may differ materially and adversely from those expressed in
      any
      forward-looking statements. Readers are directed to risks and uncertainties
      identified below, under “Risk Factors” and elsewhere in this report, for factors
      that may cause actual results to be different than those expressed in these
      forward-looking statements. Except as required by law, we undertake no
      obligation to revise or update publicly any forward-looking statements for
      any
      reason.*





**Overview**




Smart
      Online develops and markets Internet-delivered or Software-as-Services (SaS)
      software applications and data resources to start and grow small businesses.
      Many of our users are provided free use of our products. In addition, we reach
      small businesses through our own website www.smartonline.com and
      through private-label syndication arrangements with large corporations that
      private-label the Smart Online offering through their corporate web sites.
      Our
      syndication relationships provide a cost- and time-efficient way to market
      to
      the extremely large and diverse small business sector.





**Recent
      Developments.**





During
      the third quarter of 2005, Smart Online sold 786,642 shares of its common stock
      to investors for a price of $5.50 per share resulting in gross proceeds of
      $4,326,531. Smart Online incurred issuance costs totaling $245,525 related
      to
      these stock sales. Additionally, in connection with these offerings, Smart
      Online entered into Registration Rights Agreements with these shareholders.
      We
      expect to file a registration statement to register the shares sold in the
      offering and in other sales earlier during 2005 prior to November 30, 2005,
      which will be subject to SEC review before becoming effective.




During
      the third quarter of 2005, holders of warrants
      to purchase 355,428 shares of Common Stock exercised their warrants resulting
      in
      gross proceeds to Smart Online of $1,175,998.  The warrants had exercise
      prices that ranged from $1.30 to $5.00 per share.





**Market
      Launch of Version 2 of OneBiz** **SM** **Platform.** On
      November 4, 2005, we began selling Version 2 of our OneBiz SM Platform, which now contains two bundles of applications for small business
      subscribers. Our “Start” bundle is designed for companies in the start-up
      phase. Our “Grow” bundle is designed for companies that are growing their
      business. This launch permits us to commence our new sales
      campaign.





**Acquisition
      of Computility and iMart.** During
      October 2005, Smart Online acquired substantially all of the assets of
      Computility, Inc., a privately held developer and distributor of customer
      relationship management software based in Des Moines, Iowa. Smart Online intends
      to operate Computility's business under the name Smart CRM, Inc. doing business
      as Computility, Inc. Also during October 2005, Smart Online acquired all the
      stock of iMart Incorporated, a privately held developer and distributor of
      multi-channel e-commerce systems based in the Great Lakes region of the United
      States. Smart Online intends to operate iMart’s business under the name Smart
      Commerce, Inc.





**Acquisition
      Strategy.** Management determined the Computility and iMart acquisitions would be
      advantageous to Smart Online for the following reasons:





1.
            Management
                expects the acquisitions will have an accretive impact on both revenues
                and operating profit (loss).





19
 Index





2.
            iMart
                had approximately $3.4 million of revenue during 2004 and Computility
                had
                approximately $2 million of revenue during 2004. Revenues for both
                companies increased during the past two
                years.





3.
            Both
                companies have customers to whom we will seek to cross-sell Smart
                Online’s
                other software applications.





4.
            Based
                upon historical operating results and cash flows, Management expects
                that
                the future operations of iMart will fund a significant portion of
                the
                acquisition installment purchase price and non-competition payments
                obligation of Smart Online resulting from the
                acquisition.





5.
            Our
                post-acquisition strategy is to continue to operate both Computility
                and
                iMart in a similar manner as in the past, while Smart Online works
                to
                integrate their products into our OneBizSMPlatform to increase subscription sales of our core products - the
                Start
                bundle and the Grow bundle on our OneBizSMPlatform.





6.
            iMart’s
                and Computility’s product offerings will significantly broaden the
                Company’s OneBizSMPlatform and enhance existing OneBizSMPlatform. We expect to complete integration of Computility’s SalesForce
                Automation (SFA) and Customer Management Relationship (CRM) software
                into
                our OneBizSMPlatform in mid-2006. We expect iMart’s e-Commerce application will be
                fully integrated into our OneBizSMPlatform during 2006 after we release Computility’s SFA/CRM
                product.





**Computility
      Acquisition Terms.** In
      consideration for the purchased assets, Smart Online issued the seller 484,213
      shares of Smart Online common stock and assumed certain liabilities of
      Computility totaling approximately $1.9 million. In addition two key employees
      of Computility can earn up to $91,800 each over and above their base
      compensation during the fifteen months ended December 31, 2006, if certain
      performance goals are achieved. Historically, Computility derived substantially
      all of its revenue from software and hardware subscription agreements which
      typically have 3-year terms with substantial penalties for early termination.
      Until the date of the acquisition, Computility factored substantially all of
      its
      subscription agreements and received approximately 65% of the expected cash
      flow
      from the subscription period upfront and used the cash to fund on-going
      operations. As a result of the factoring arrangements, Smart Online will be
      required to provide services to the customers, but will only receive
      approximately 35% of the corresponding customer payments. Additionally, as
      a
      result of this factoring activity and based on contracts signed as of the date
      of acquisition, management expects that the acquisition will result in an
      approximate $100,000 monthly increase in cash expenditures for the remainder
      of
      2005.





**iMart
      Acquisition Terms.** Smart
      Online issued to iMart’s stockholders 205,767 shares of our Common Stock and
      will pay iMart’s stockholders $3,366,000 in cash. The cash is payable in four
      equal payments of $420,750 on the first business day of each of January 2006,
      April 2006, July 2006 and October 2006. The remaining $1,683,000 is payable
      in
      January 2007. In addition, Smart Online is to pay $780,000 for noncompetition
      agreements to key personnel of the acquired company in eight equal quarterly
      installments during the period beginning in January 2006 and ending October
      in
      2007. The cash payments are secured by the net proceeds of customer contracts
      of
      iMart, which will limit our ability to use cash derived from iMart revenue
      in
      our business until all required cash obligations are paid to iMart shareholders
      and employees. The former CEO of iMart has contractual rights to continue
      operate iMart within agreed financial parameters. See “Note 7 of Notes to
      Financial Statements” for a summary of the iMart acquisition terms.





The
      effect of the Computility acquisition and the iMart acquisition on the cash
      resources and needs of Smart Online is not known at this time and will not
      be
      known until Smart Online develops a history of operating the acquired entities.
      However, substantial expenses were incurred in professional fees in connection
      with these transactions, and it is anticipated that substantial costs will
      be
      incurred in integrating the acquired companies into Smart Online. Management
      believes that the acquisitions will initially result in greater working capital
      needs as we expect Smart Online will not acquire substantial accounts
      receivables. Management believes these acquisitions will eventually result
      in
      positive cash flow to Smart Online, but the initial effect on Smart Online’s
      working capital will be negative. The acquisitions present both opportunities
      and risks for Smart Online. See “Risk Factors” Numbers (13) and (14) for
      discussion of certain risks associated with the acquisitions.




**Accounting
      Software Acquisition Terms**.  During August 2005, Smart
      Online entered into a software assignment and development agreement with a
      developer of customized software applications that provides for the assignment
      and customization of certain accounting software. The initial integration of
      this product in the OneBizSM Platform was completed in September
      2005, with the remainder planned for December 2005.  In connection with
      this agreement, Smart Online agreed to pay the developer up to $512,500 and
      issue up to $287,500 worth of Smart Online Common Stock based upon the
      developer attaining certain milestones.  As of September 30, 2005 the
      developer had earned and been paid $105,000 ($90,000 in cash and $15,000 of
      Smart Online Common Stock).





**SUMMARY**





**OneBiz** **SM** **** **Platform**





Smart
      Online has made significant improvements to
      its OneBizSM Platform, including enhancements to its
      dashboard and adding additional software applications.  We plan to make
      additional improvements during the fourth quarter of 2005 and the first half
      of
      2006. These enhancements include a combination of internal development,
      joint development, licensing from other companies, and acquisitions. Our
      OneBizSM Platform is being released in three versions. The first
      version was released during the first quarter of 2005. We began offering our
      primary products, our Start bundle of software applications and our Grow bundle
      of software applications, as part of the second version of our
      OneBizSM Platform in November 2005.  At present these bundles
      are only offered on the Smart Online website, but we may make the
      bundles available on syndication sites during the remainder of fourth
      quarter of 2005 and during the first quarter of 2006, if our syndication
      partners permit. The third version
      of OneBizSM Platform is planned to be released at the
      end of the fourth quarter 2005. We plan to integrate certain iMart and
      Computility products into our OneBizSM Platform products during
      2006.   Smart Online is evaluating its development
      priorities in light of its recent acquisition of Computility and iMart and
      expects that some previously featured parts of the third version may be
      modified, delayed, or eliminated in light of new development priorities. 
In that regard, the following features contained in the third version, as
      previously disclosed, may not be released on or before December 31,
      2005: Dashboard,
      detail drill-down views & capabilities; Dashboard, dynamically update OneBiz
      functionality based on state of business; HR, professional training (continuing
      education); Shipping (advanced features); Printing & copying
      services.




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Since
      2000, Smart Online’s major focus has been on developing and validating our
      online content, applications, services, delivery platform and user interface.
      To
      validate the platform, services, and products, many customers received access
      to
      the Smart Online products and portal free-of-charge in exchange for their
      evaluation and feedback. Smart
      Online has recently begun to develop targeted programs to market and sell the
      Smart Online offerings. These efforts are targeted to direct customer
      acquisition and retention, recovery of former customers and closing on new
      syndication partnerships.





During
      2004, Smart Online recognized approximately $1.0 million of revenue. In
      addition, Smart Online had deferred revenue of approximately $722,000 at
      December 31, 2004. Smart Online recognized revenue totaling approximately $1.3
      million in 2003 and approximately $1.4 million in 2002. During 2004, Smart
      Online entered into several new syndication and integration agreements totaling
      approximately $1.2 million, including $640,000 of barter transactions. We are
      planning to substantially increase our advertising and marketing in future
      years. We have started to enter into new syndication partnerships that target
      strategic partners for bartering arrangements for advertising and joint
      marketing programs to take advantage of discounted advertising rates and to
      provide an opportunity for us to share in the revenue generated by our
      syndication partners from use of our platform. We began targeting small business
      media companies during the first quarter of 2004, such as Inc. Magazine,
      FastCompany Magazine, and Business Week, who have small-business customer bases.
      Smart Online anticipates the revenue share arrangements with the media companies
      will enable it to increase web services revenue for both Smart Online and its
      private label syndication partners as we begin to share in the revenue our
      partners generate from their websites. We expect to create these arrangements
      in
      the future with media companies who offer the ability to reach small-business
      customers and assist in off-setting Smart Online’s cash expenditures for print
      and online advertising and marketing. While we intend to derive a majority
      of
      our syndication revenue from traditional non-barter transactions, we will
      evaluate barter transactions on a case-by-case basis when we believe such
      transactions make economic or strategic sense. Pursuant to the requirements
      of
      Emerging Issues Task Force (EITF) No. 93-11, *Accounting
      for Barter Transactions Involving Barter Credits* ,
      and
      EITF 99-13, *Accounting
      for Advertising Barter Transactions* ,
      for the
      year ended December 31, 2004, Smart Online recognized approximately $113,000
      of
      barter revenue.





To
      increase our revenues and take advantage of our market opportunity, we will
      need
      to add substantial numbers of paying subscribers. We define paying subscriptions
      as unique user accounts. We plan to re-invest earnings for the foreseeable
      future in the following ways: hiring additional personnel, particularly in
      marketing and sales; expanding marketing and sales activities; increasing our
      research and development activities to upgrade and extend our service offerings
      and to develop new services and technologies; adding to our infrastructure
      to
      support our growth; and formalizing our operational and financial systems to
      manage a growing business.





We
      expect
      sales and marketing costs, which included third-party advertising and marketing
      expenses of approximately $16,000, $130,000, and $171,000 for 2002, 2003, and
      2004, respectively, to increase substantially in dollars and as a percent of
      total expenses in the future as we seek to add and manage more paying
      subscribers, build brand awareness and increase the number of marketing and
      sales programs implemented.





**Fiscal
      Year**





Our
      fiscal year ends on December 31. References to fiscal 2004, for example, refer
      to the calendar year ended December 31, 2004.





**Sources
      of Revenue**





Smart
      Online currently derives revenues from the following sources:





·
            Syndication
                Fees - fees consisting of:





o
            Fees
                charged to syndication partners to create a customized private-label
                site.


o
            Barter
                revenue derived from syndication agreements with media
                companies.





·
            Integration
                Fees - fees charged to partners to integrate their products into
                the Smart
                Online syndication platform. Integrating third-party content and
                products
                has been a key component of Smart Online’s strategy to continuously expand
                and enhance its platform offered to syndication partners and its
                own
                customer base.


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·
            Web
                Services fees - comprised of the
                following:





o
            E-commerce
                sales directly to end-users:





·
            Subscription





·
            Multiuser
                subscription paid by enterprises for their business
                customers





·
            A
                la carte





·
            E-commerce
                revenue sharing with integration
                partners





·
            OneBizSMPlatform





·
            Contextual
                integration (“CI”) advertising fee





o
            Hosting
                and maintenance fees





o
            E-commerce
                Website Design and Build





o
            Loan
                origination fees





o
            Online
                marketing to our syndication/integration
                partners





o
            Marketing
                fee for loan request through the integrated
                platform





·
            OEM
                agreements with third-party computer manufacturers for various individual
                Smart Online applications.





·
            Other
                Revenues - Includes revenues generated from consulting fees and the
                sale
                of legacy shrink-wrapped products.





Smart
      Online also plans to seek new sources of revenue, including the following
      sources:





·
            Technology
                Platform Licensing Revenue - We plan to seek to generate revenue
                from
                licensing our technology platform.





·
            Advertising
                Revenue - We plan to add direct advertising revenue in the
                future.





During
      2004, we entered into several new syndication and integration partnerships
      with
      targeted strategic partners, whereby we will receive a percentage of the revenue
      generated by our partners from their websites. These agreements also included
      bartering arrangements for advertising and joint marketing programs to take
      advantage of discounted advertising rates and to provide an opportunity for
      revenue sharing. These new partnerships mean that our products could be
      accessed by more than 4 million small business prospects who use the
      websites of our syndication partners, but we must devise ways to more actively
      sell to these potential users. Smart Online embarked on this program based
      on
      the success of the revenue share strategy, illustrated by Google, Overture
      Services, and CareerBuilder, where media companies provide these services to
      their customers to increase revenue for both companies. Smart Online began
      targeting small business media companies during the first quarter of 2004,
      such
      as Inc. Magazine, FastCompany Magazine, and Business Week, who have small
      business customer bases. We estimate our revenue share arrangements with the
      media companies will enable us to increase web services revenue for both Smart
      Online and our private label syndication partners while creating an advantage
      over potential competitors. Smart Online expects to create certain types of
      these arrangements in the future with media companies who offer the ability
      to
      reach small business customers and will assist in off-setting Smart Online’s
      outlay of cash for more costly print and online advertising and marketing.
      While
      we intend to derive a majority of our syndication revenue from traditional
      non-barter transactions, we will evaluate barter transactions on a case-by-case
      basis when we believe such transactions make economic or strategic sense. During
      2004 Smart Online signed syndication contracts with Inc. Magazine, FastCompany
      Magazine, and Business Week. In addition we have embarked on a telesales effort
      to up sell current users to additional Smart Online services and to bring former
      users back to Smart Online.


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Both
      syndication and integration fees are recognized on a monthly basis over the
      life
      of the contract, although a significant portion of the fee from integration
      is
      received upfront. Our contract and support contracts are noncancelable, though
      customers typically have the right to terminate their contracts for cause if
      we
      fail to perform. We generally invoice our paying customers in annual or monthly
      installments and typical payment terms provide that our customers pay us within
      30 days of invoice. Amounts that have been invoiced are recorded in accounts
      receivable and in deferred revenue or revenue depending on whether the revenue
      recognition criteria have been met. In general, we collect our billings in
      advance of the service period. Online marketing, which consists of marketing
      services provided to our integration and syndication partners have in the past
      generated additional revenue. In addition, certain users have requested that
      Smart Online implement online marketing initiatives for them, such as promoting
      their products through Google or Overture Services. Online marketing has not
      been a material source of past revenue. We intend to see an increase in the
      level of online marketing services in the future.





Web
      Services revenues are comprised of e-commerce sales directly to end-users,
      hosting and maintenance fees, e-commerce website design fees and online loan
      origination fees. E-commerce sales are made either on a subscription or a la
      carte basis. Subscriptions, which include access to most Smart Online offerings,
      are payable in advance on a monthly basis and are targeted at small companies
      or
      divisions of large companies. We will seek to grow our revenue, including
      monthly subscription volume, substantially over the next 24 months as new
      versions of Smart Online’s platforms (OneBizSM Platform) are
      released. We do not expect to report significant subscription revenues until
      2006, because we need time to market and to invest more on marketing and sales
      before significant revenue is generated. Historically, most of our users have
      been given free use of our products for extended time periods. We recently
      changed that policy to a limited 30-day free use period, after which we
      terminate access for users who fail to become paid subscribers. Our monthly
      subscription fees will be in the range of $29.95 to $49.95 for bundles
      of software applications (depending on the number of subscriber personnel using
      our software) for new subscribers direct through www.smartonline.com
      after a free trial period. We expect lower fees from subscribers at the private
      label syndication websites of our partners. Currently, most of our syndication
      agreements call for us to receive 50% of revenue generated. We began to offer
      our Start bundle of software applications and our Grow bundle of software
      applications on November 4, 2005 on our own website, and we may add
      these bundles to the websites of our syndication partners during the remainder
      of fourth quarter of 2005 and the first quarter of 2006, if our syndication
      partners permit us to change their websites.  A la carte pricing, which
      allows customers to purchase one-time use of a specific software or content
      service, ranges from $10 to $300, which can include third-party charges when
      applicable, such as state and federal fees associated with incorporating a
      business or additional fees associated with having a press release written
      and
      revised. We also recently began to offer to our syndication partners value
      discounts for pre-paid subscriptions, which they can either resell or contribute
      to their small business customers. The changes to our subscription policies
      are
      too recent for us to determine how they will affect our revenues.





Additionally,
      Smart Online receives a portion of third-party sales of products and services
      through revenue sharing arrangements, which involves a split of realized
      revenues. Hosting and maintenance fees are charged for supporting and
      maintaining the private-label portal and providing customer and technical
      support directly to our syndication partner’s users and are recognized on a
      monthly basis. E-commerce website design fees which are charged for building
      and
      maintaining corporate websites or to add the capability for e-commerce
      transactions, are recognized over the life of the project. We have discontinued
      our third-party arrangement for online web design. We expect to resume this
      service after a new partner is under contract. Online loan origination fees
      are
      charged to provide users online financing option by which Smart Online receives
      payments for loan or credit provided. We intend to become more aggressive about
      promoting this product offering in the future.





Revenues
      from OEM arrangements are reported and paid to Smart Online on a quarterly
      basis
      and are subject to certain contractual minimum volumes.





Other
      revenues consist primarily of traditional shrink-wrap sales, which are not
      a
      core revenue source for Smart Online. We expect that consulting fees, which
      in
      the past have generated significant revenues, will not be a material revenue
      source in the future.





**Revenue
      From Related Parties**





Approximately
      32.9%, 27.2%, and 9.2% of total revenues for the years ended December 31, 2004,
      2003, and 2002, respectively, were from a single customer, Smart IL Ltd.
      (“SIL”), formerly known as Smart Revenue Europe Ltd., an Israel based software
      company that specialized in secured instant messaging products. During March
      2004 SIL ceased further development of its technology and laid-off all employees
      after SIL completed development of, and delivered to us, its instant messenger
      product. SIL is currently seeking to license or sell its technology, however,
      we
      do not expect to receive substantial revenue from SIL in the future. SIL is
      owned by Doron Roethler, a shareholder of Smart Online.





On
      August
      13, 2002, Smart Online entered into an integration agreement with SIL to
      incorporate its products into Smart Online’s platform. As part of this
      agreement, SIL paid $300,000 for such integration, and the parties agreed to
      share future revenues generated from the sales of the products. On August 30,
      2002, the parties signed an amendment to the original agreement, in order
      for Smart Online to provide SIL certain co-development services, which includes
      instant messenger and video conferencing. In exchange, SIL paid Smart Online
      an
      additional $300,000. The parties further agreed that the products developed
      as a
      result of both companies’ efforts


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would
      be
      owned by both parties. On April 30, 2003, Smart Online and SIL signed a new
      amendment and restated the integration program agreement. According to this
      new
      amendment and restated agreement, Smart Online agreed to fund the future
      development of the products. In exchange SIL agreed to limit future amounts
      payable by Smart Online under the original share revenue agreement to $1.7
      million. This cap on revenue sharing was removed by amendment on October 29,
      2003.





In
      addition to the agreements described above, on August 30, 2002, Smart Online
      and
      SIL also entered into a reseller agreement whereby SIL paid Smart Online
      $200,000 for nonexclusive rights to distribute Smart Online’s products in the
      territories of Israel, United Kingdom, France, Italy, Netherlands, and Spain,
      in
      exchange for Smart Online’s marketing support and a twenty percent commission
      from the gross sales generated by SIL. On March 17 and 27, 2003, the parties
      subsequently modified the original re-seller agreement to restrict the territory
      to only Israel and Netherlands. We expect no revenue from SIL, unless SIL hires
      employees to sell our products. We do not know whether SIL intends to hire
      employees to sell our products. Additionally, on December 22, 2003, Smart Online
      signed a private label syndication agreement with SIL for Smart Online to
      provide website development for SIL’s website.





Smart
      Online paid $3,300 to SIL for moving expenses with regard to the SIL development
      team visiting Smart Online from Israel in January of 2003. Smart Online also
      paid SIL $25,000 as a reseller payment for the Moneris Integration contract
      they
      secured pursuant to their re-seller agreement in May of 2003. Smart Online
      also
      paid SIL $90,000 pursuant to their contract dated December 20, 2003 for
      technical co-development work, which includes instant messenger and video
      conferencing, on a monthly payment of $15,000 starting in December of 2003
      and
      ending in May of 2004.





During
      2003, Smart Online provided $20,200 in consulting services to Small Business
      Lending Institute, Inc. (“SBLI”). This constituted approximately 1.6% of Smart
      Online’s revenue during 2003. Tamir Sagie, an officer of Smart Online at the
      time, is an officer of SBLI. Michael Nouri, the Chief Executive Officer of
      Smart
      Online is a shareholder in SBLI. Smart Online paid $221,517 to SBLI during
      the
      first three months of 2004, because SBLI paid Smart Online’s employees during
      the first quarter of 2004 while Smart Online was dealing with a tax matter
      with
      the Internal Revenue Service. The temporary transfer of Smart Online's employees
      to SBLI allowed Smart Online to obtain a clean cut off to determine the extent
      of its tax liability.





Approximately
      11.9% of total revenues for the year ended December 31, 2003, and 0% for the
      year ended December 31, 2004, were from a third related company, Parson and
      Shearson, Inc., which is owned 50% by the CEO of Smart Online, Michael Nouri,
      and 50% by his brother Eric Nouri. This revenue related to services performed
      by
      Smart Online for the development of web-based human resources and inventory
      applications for Parson and Shearson. Parson and Shearson has paid in full
      for
      all services and has no outstanding amounts payable to Smart
      Online.





The
      following is a summary of related party revenues for the nine months ended
      September 30, 2005 and 2004 (unaudited), and for the years ended December 31,
      2004, 2003 and 2002.





**Nine
                Months Ended**
              **SEPTEMBER
                30, 2005**
              **(unaudited)**
            
            
            **Nine
                Months Ended**
              **SEPTEMBER
                30, 2004**
              **(unaudited)**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2004**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2003**
            
            **Year
                Ended**
              **DECEMBER
                31,**
              **2002**Smart
                II, Ltd. ("SIL"), formerly
              known
                as Smart Revenue Europe
              Ltd.
                - Integration fees
            
            $
            -
            
            $
            247,538
            
            $
            330,050
            
            $
            342,857
            
            $
            128,571Parson
                and Shearson, Inc. -
              Consulting
                Services
            
            
            -
            
            
            -
            
            
            -
            
            
            150,000
            
            
            -Small
                Business Lending Institute
              Consulting
                Services
            
            
            -
            
            
            -
            
            
            -
            
            
            20,200
            
            
            -Total
                Related Party Revenues
            
            $
            -
            
            $
            247,538
            
            $
            330,050
            
            $
            513,057
            
            $
            -





Accordingly,
      approximately 32.9% of year 2004 and 40.7% of year 2003 total revenue were
      derived from related parties. Smart Online expects revenue from related parties
      will not continue to be a significant part of Smart Online’s revenue. If Smart
      Online fails to replace revenue from related parties with revenue from unrelated
      parties, Smart Online’s revenue will decrease.


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**Cost
      of Revenues**





*Cost
      of Revenues* .
      Historically, Smart Online has not capitalized, and subsequently amortized
      as a
      component of cost of revenues, any costs associated with the development of
      its
      products and platform. SFAS No. 86, *Accounting
      for the Costs of Software to be Sold, Leased or Otherwise
      Marketed* ,
      requires capitalization of certain software development costs subsequent to
      the
      establishment of technological feasibility. Based on the Smart Online’s product
      development process, technological feasibility is established upon completion
      of
      a working model. Costs related to software development incurred between
      completion of the working model and the point at which the product is ready
      for
      general release have been insignificant. Cost of revenues is comprised primarily
      of salaries and related employee expenses associated with employees who provide
      maintenance and support services. Additionally, during 2002 and a portion of
      2003 cost of revenues included third-party website hosting fees.





During
      the third quarter of 2005, Smart Online acquire certain rights to an accounting
      software application that is currently being integrated with the Company’s
      OneBiz SM Platform. During the third quarter of 2005, Smart Online capitalized $110,000
      of
      costs associated with this acquired software. These capitalized costs will
      be
      amortized into cost of revenues over the expected useful life of the software
      commencing in the fourth quarter of 2005.





**Operating
      Expenses**





During
      2002, 2003, and 2004 our efforts were primarily focused on product development
      and integration. During the first quarter of 2002, we substantially reduced
      the
      number of people we employed. Smart Online employed approximately 13 full-time
      equivalent employees during 2002 and 2003. During 2004, Smart Online hired
      additional development and sales staff and had 18 full-time employees at
      December 31, 2004. Most employees performed multiple functions.





*Research
      and Development*. We have historically focused our research and development
      activities on increasing the functionality and enhancing the ease of use of
      our
      on-demand application service. Because of our proprietary, scalable and secure
      multi-user architecture, we are able to provide all customers with a service
      based on a single version of our application. As a result, we do not have to
      maintain multiple versions, which enables us to have relatively low research
      and
      development expenses as compared to traditional enterprise software business
      models. We expect that in the future, research and development expenses will
      increase substantially in absolute dollars as we upgrade and extend our service
      offerings and develop new technologies. We expect this to be particularly true
      during 2004 and 2005 as we incur expenses to develop our next generation
      OneBizSM Platform and during 2006 as we integrate the products we
      acquired from recent acquisitions onto our platform.





*Marketing
      and Sales* .
      During
      2002, 2003, and 2004, Smart Online spent limited funds on marketing,
      advertising, and public relations. During the first two quarters of 2005, Smart
      Online incurred marketing and selling expenses of approximately $290,000 per
      quarter.  During the third quarter, marketing and sales expenses increased
      by approximately 30% as compared to the second quarter.  We expect these
      expenditures to increase significantly during the remainder of 2005 as we launch
      and begin marketing our latest version of the OneBizSM
      Platform.  We expect
      this trend to continue into 2006 and beyond as we strive to grow our revenue.
      Smart Online has also embarked on an effort to develop programs where media
      companies provide Smart Online’s Private Label Syndication services to their
      small business end users. Smart Online began targeting small business media
      companies in the first quarter of 2004, such as Inc. Magazine, FastCompany
      Magazine, and Business Week, who have small business customer bases. The
      strategy has been to implement Private Label Syndication platforms in exchange
      for advertising and joint marketing programs with these companies. Smart Online
      estimates the revenue capabilities from its back-end revenue share arrangements
      with these contracts will enable it to increase web services revenue for both
      Smart Online and its partners beginning during the fourth quarter of 2005,
      although substantial revenue increases over the twenty-four month period after
      we release our new product are expected to occur only after we have sufficient
      time to sell our new product and after we invest substantially greater amounts
      in marketing and sales. Smart Online expects to create certain types of these
      arrangements in the future with media companies who offer the ability to reach
      small business customers and will assist in off-setting Smart Online’s outlay of
      cash for print and online advertising and marketing while providing reduced
      advertising prices. Media companies are requesting such services to assist
      in
      driving additional revenue.





Generally,
      we expect we will have to increase marketing and sales expenses before we can
      substantially increase our revenue from sales of subscriptions. We plan to
      invest heavily in marketing and sales by increasing the number of direct sales
      personnel and increase penetration within our existing customer base, expanding
      our domestic and international selling and marketing activities, building brand
      awareness and participating in additional marketing programs. We expect that
      in
      the future, marketing and sales expenses will increase in absolute dollars
      and
      will be a significant cost.





*General
      and Administrative* .
      General
      and administrative expenses consist of salaries and related expenses for
      executive, finance and accounting, human resources, and management information
      systems personnel, professional fees, and other corporate expenses, including
      facilities costs. General and administrative expenses have increased and
      will continue to increase as we add personnel and incur additional professional
      fees and insurance costs related to the growth of our business and to our
      operations as a public company.


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*Stock-Based
        Expenses* .
        Our
        operating expenses include stock-based expenses related to options and warrants
        issued to employees and non-employees. These charges have been significant
        and
        are reflected in our historical financial results. In addition, in connection
        with the issuance of 1,273,000 shares of our Common Stock in exchange for
        investor relations services, including 1,250,000 of which were issued in
        the
        fourth quarter of 2005, we expect to incur non-cash expenses equal to the
        market
        value of the shares.


**Critical
      Accounting Policies and Estimates**





Our
      discussion and analysis of financial condition and results of operations are
      based upon our consolidated financial statements, which have been prepared
      in
      accordance with accounting principles generally accepted in the United States.
      The preparation of these financial statements requires us to make estimates
      and
      judgments that affect the reported amounts of assets, liabilities, revenues
      and
      expenses, and related disclosures of contingent assets and liabilities.
“Critical accounting policies and estimates” are defined as those most important
      to the financial statement presentation and that require the most difficult,
      subjective, or complex judgments. We base our estimates on historical experience
      and on various other factors that we believe to be reasonable under the
      circumstances, the results of which form the basis for making judgments about
      the carrying value of assets and liabilities that are not readily apparent
      from
      other sources. Under different assumptions and/or conditions, actual results
      of
      operations may materially differ. We periodically re-evaluate our critical
      accounting policies and estimates, including those related to revenue
      recognition, provision for doubtful accounts and sales returns, expected lives
      of customer relationships, useful lives of intangible assets and property and
      equipment, provision for income taxes, valuation of deferred tax assets and
      liabilities, and contingencies and litigation reserves. We presently believe
      the
      following critical accounting policies involve the most significant judgments
      and estimates used in the preparation of our consolidated financial
      statements.





*Revenue
      Recognition* -
      We
      recognize revenue in accordance with accounting standards for software and
      service companies including the United States Securities Exchange Commission
      (“SEC”) Staff Accounting Bulletin 104, *Revenue
      Recognition* (“SAB
      104”), Emerging Issues Task Force Issue No. 00-2, *Revenue
      Arrangements with Multiple Deliverables* (“EITF
      00-21”) *,* and
      related interpretations including American Institute of Certified Public
      Accountants (“AICPA”) Technical Practice Aids. We also utilize interpretative
      guidance from regulatory and accounting bodies, which include, but are not
      limited to, the SEC, the AICPA, the Financial Accounting Standards Board
      (“FASB”), and various professional organizations.





We
      recognize revenue when all of the following conditions are satisfied: (1) there
      is persuasive evidence of an arrangement; (2) the service has been provided
      to
      the customer; (3) the collection of our fees is probable; and (4) the amount
      of
      fees to be paid by the customer is fixed or determinable. EITF 00-21 states
      that
      revenue arrangements with multiple deliverables should be divided into separate
      units of accounting if the deliverables in the arrangement meet the following
      criteria: 1) the delivered item has value to the customer on a standalone basis;
      2) there is objective and reliable evidence of the fair value of the undelivered
      item; and 3) if the arrangement includes a general right of return relative
      to
      the delivered item, delivery or performance of the undelivered item is
      considered probable and substantially in control of the vendor. Smart Online’s
      syndication and integration agreements typically include multiple deliverables
      including the grant of a non-exclusive license to distribute, use and access
      the
      Smart Online platform, fees for the integration of content into the Smart Online
      platform, maintenance and hosting fees, documentation and training, and
      technical support and customer support fees. Smart Online cannot establish
      fair
      value of the individual revenue deliverables based on objective and reliable
      evidence because Smart Online does not have a long, consistent history of
      standard syndication and integration contractual arrangements, there have only
      been a few contracts that have continued past the initial contractual term,
      Smart Online does not have any contracts in which these elements have been
      sold
      as stand-alone items, and there is no third-party evidence of fair value for
      products or services that are interchangeable and comparable to the Smart
      Online’s products and services. As such, Smart Online can not allocate revenue
      to the individual deliverables and must record all revenues received as a single
      unit of accounting as further described below. Additionally, Smart Online has
      evaluated the timing and substantive nature of the performance obligations
      associated with the multiple deliverables noted above, including the
      determination that the remaining obligations are essential to the on-going
      usability and functionality of the delivered products, and determined that
      revenue should be recognized over the life of the contracts, commencing on
      the
      date the site goes on-line, due to such factors as the length of time over
      which
      the remaining obligations will be performed, the complex nature of integrating
      and maintaining customer content with Smart Online’s platform which services are
      unavailable from other vendors, and the timing of payment of a portion of the
      contract price such as monthly hosting payments.





Syndication
      fees consist primarily of fees charged to syndication partners to create and
      maintain a customized private-label site and ongoing support, maintenance and
      customer service. Our syndication agreements typically include an advance fee
      and monthly hosting fees. We generally invoice our customers in annual or
      monthly installments and typical payment terms provide that our customers pay
      us
      within 30 days of invoice. Amounts that have been invoiced are recorded as
      accounts receivable and in deferred revenue and the revenue is recognized
      ratably over the specified lives of the contracts, commencing on the date the
      site goes on-line. In general, we collect our billings in advance of the service
      period. Our hosting fees are typically billed on a monthly basis. We


26
 Index


continue
      to evaluate and adjust the length of these amortization periods as we gain
      more
      experience with implementation schedules and contract cancellations. At present,
      Smart Online has insufficient historical data to determine if the relationship
      with its existing customers will extend beyond the initial term with the
      customer continuing to benefit from the advance fee. If Smart Online determines
      that existing and/or future contracts are expected to extend beyond the initial
      term whereby the customer continuing to benefit from the advance fee, Smart
      Online will extend the revenue recognition period accordingly to include the
      extended term. Our syndication contracts and support contracts typically provide
      for early termination only upon a material breach by either party that is not
      cured in a timely manner. If a contract terminates earlier than its term, we
      recognize the remaining deferred revenue upon termination. Based on that
      experience, it is possible that, in the future, the estimates of expected
      duration of customer contract lives may change and, in such event, the period
      over which such syndication revenues are amortized will be adjusted. Any such
      change in specified contract lives will affect our future results of operations.
      Additionally, the syndication contracts typically include revenue sharing
      arrangements whereby syndication partners typically charge their customers
      a
      monthly fee to access the private-label site. In most cases, the syndication
      agreements provide for Smart Online to receive a percentage of these fees.
      Fees
      derived from such revenue sharing arrangements are recorded when earned. To
      date, such revenue sharing fees have been negligible.





Integration
      fees consist primarily of fees charged to integration partners to integrate
      their products into the Smart Online syndication platform. Integrating
      third-party content and products has been a key component of Smart Online’s
      strategy to continuously expand and enhance its platform offered to syndication
      partners and its own customer’s base. We generally invoice our customers in
      advance of the service period in annual or monthly installments and typical
      payment terms provide that our customers must pay us within 30 days of invoice.
      Amounts that have been invoiced are recorded in accounts receivable and in
      deferred revenue and the revenue is recognized ratably over the specified lives
      of the contracts, commencing on the date the site goes on-line. We continue
      to
      evaluate and adjust the length of these amortization periods as we gain more
      experience with implementation schedules and contract cancellations. At present,
      Smart Online has insufficient historical data to determine if the relationship
      with its existing customers will extend beyond the initial term with the
      customer continuing to benefit from the advance fee. If Smart Online determines
      that existing and/or future contracts are expected to extend beyond the initial
      term whereby the customer continuing to benefit from the advance fee, Smart
      Online will extend the revenue recognition period accordingly to include the
      extended term. Our integration contracts and support contracts typically provide
      for early termination only upon a material breach by either party that is not
      cured in a timely manner. If a contract terminates earlier than its term, we
      recognize the remaining deferred revenue upon termination. Based on that
      experience, it is possible that, in the future, the estimates of expected
      implementation periods and customer lives may change. In such event, the period
      over which such syndication revenues are amortized will be adjusted. Any such
      change in specified contract lives will affect our future results of operations.
      Additionally, integration agreements typically include an upfront fee and a
      revenue sharing component. Fees derived from such revenue sharing arrangements
      are recorded when earned. To date, such revenue sharing fees have been
      negligible.





Both
      syndication and integration fees are recognized on a monthly basis over the
      life
      of the contract, although a significant portion of the fee from integration
      agreements is received upfront. We generally invoice our customers in annual
      or
      monthly installments and typical payment terms provide that our customers are
      required to pay us within 30 days of invoice. Amounts that have been invoiced
      are recorded in accounts receivable and in deferred revenue or revenue depending
      on whether the revenue recognition criteria have been met. In general, we
      collect our billings in advance of the service period. Online marketing, which
      consists of marketing services provided to our integration and syndication
      partners have in the past generated additional revenue. In addition, certain
      users have requested that Smart Online implement online marketing initiatives
      for them, such as promoting their products through Google or Overture Services.
      Online marketing has not been a material source of revenue in the past. We
      expect to increase our online marketing services revenue in the
      future.





OEM
        revenues are recorded based on the greater of actual sales or contractual
        minimum guaranteed royalty payments. Smart Online records the minimum guaranteed
        royalties monthly and receives payment of the royalties on a quarterly basis,
        thirty days in arrears. To the extent actual royalties exceed the minimum
        guaranteed royalties, the excess is recorded in the quarter Smart Online
        receives notification of such additional royalties.




Web
      Services revenues are comprised of e-commerce sales directly to end-users,
      hosting and maintenance fees, e-commerce website design fees and online loan
      origination fees. E-commerce sales are made either on a subscription or a la
      carte basis. Subscription, which provides users with access to most of our
      products is payable in advance on a monthly basis and is targeted at small
      companies or small divisions of large companies. We will seek to grow our
      monthly subscription volume substantially over the 24 months after new versions
      of Smart Online’s platforms (OneBizSM Platform) are released.
      Historically, most of our users have been given free use of our products for
      extended time periods. We recently changed that policy to a limited 30-day
      free
      use period, after which we terminate access for users who fail to become paid
      subscribers. We do not expect to report significant subscription revenue until
      2006, because we need time to market and invest more in marketing and sales.
      Our
      monthly subscription fees will be typically in the range of $29.95 to
      $49.95 for bundles of software applications (depending on the number of
      subscriber personnel using our software) for new subscribers at
www.smartonline.com, although until recently we have given free access to
      our web services to most users. We expect lower fees from subscribers at the
      private label syndication websites of our partners. Currently, most of our
      syndication agreements call for us to receive 50% of revenue generated. On
      November 4, 2005, we began to offer our Start bundle of software applications
      and our Grow bundle of software applications on our own website, and we may
      add these bundles to the websites of our syndication partners during the
      remainder of fourth quarter of 2005 and the first quarter of 2006, if our
      syndication partners permit us to change their websites. A la carte
      pricing, which allows customers to purchase one-time use of a specific software
      or content service, ranges from $10 to $300, which includes third-party charges
      when applicable, such as state and federal fees associated with incorporating
      a
      business or additional fees associated with having a press release written
      and
      revised. We also recently began to offer to our syndication partners value
      discounts for pre-paid subscriptions, which they can either resell or contribute
      to their small business customers. Our changes to our subscription policies
      are
      too recent for us to determine how they will affect our
      revenues.


27
 Index


Additionally,
      Smart Online receives a portion of revenue from third-party sales of products
      and services through our website and websites of our syndication partners from
      revenue sharing arrangements, which involves a split of realized revenues.
      Hosting and maintenance fees are charged for supporting and maintaining the
      private-label portal and providing customer and technical support directly
      to
      our syndication partner’s users and are recognized on a monthly basis.
      E-commerce website design fees, which are charged for building and maintaining
      corporate websites or to add the capability for e-commerce transactions, are
      recognized over the life of the project. We have discontinued our third-party
      arrangement for online web design. We expect to resume this service after a
      new
      partner is under contract. Online loan origination fees are charged to provide
      users online financing options. Smart Online receives payments for loans or
      credit provided. We intend to become more aggressive about promoting this
      service in the future.





Subscription
      revenue is recognized ratably over the subscription period (usually one year).
      Third-party premium products are shared with integration partners.




Consulting
      revenues are recognized over the term of the consulting engagement as services
      are performed, which is typically one to three months. Advance payments for
      consulting services, if billed and paid prior to completion of the project,
      are
      recorded as deferred revenue when received. If the fees are not fixed or
      determinable, revenue is recognized as payments are received from the customer.





*Barter
      Transactions* -
      Barter
      revenue relates to syndication and integration services provided by Smart Online
      to business customers in exchange for advertising in the customers’ trade
      magazines and on their Web sites. Barter expenses reflect the expense offset
      to
      barter revenue. The amount of barter revenue and expense is recorded at the
      estimated fair value of the services received or the services provided,
      whichever is more objectively determinable, in the month the services and
      advertising are exchanged. Smart Online applies APB 29, Accounting for
      Non-Monetary Transactions, the provisions of EITF 93-11, *Accounting
      for Advertising Barter Transactions Involving Barter Credits* and
      EITF
      99-13, *Accounting
      for Advertising and Barter Transactions* and,
      accordingly, recognizes barter revenues only to the extent that Smart Online
      has
      similar cash transactions within a period not to exceed six months prior to
      the
      date of the barter transaction. To date the amount of barter revenue to be
      recognized has been more objectively determinable based on integration and
      syndication services provided. For revenue from integration and syndication
      services provided for cash to be considered similar to the integration and
      syndication services provided in barter transactions, the services rendered
      must
      have been in the same media and similar term as the barter transaction. Further,
      the quantity or volume of integration or syndication revenue recorded in a
      qualifying past cash transaction can only evidence the fair value of an
      equivalent quantity or volume of integration or syndication revenue recorded
      in
      subsequent barter transactions. In other words, a past cash transaction can
      only
      support the recognition of revenue on integration and syndication contracts
      barter transactions up to the dollar amount of the cash transactions. When
      the
      cash transaction has been used to support an equivalent quantity and dollar
      amount of barter revenue, that transaction cannot serve as evidence of fair
      value for any other barter transaction. Once the value of the barter revenue
      has
      been determined, Smart Online follows the same revenue recognition principles
      as
      it applies to cash transactions with unearned revenues being deferred as
      described more fully under the caption “ *Revenue
      Recognition* ”
above.
      At the time the barter revenue is recorded, an offsetting pre-paid barter
      advertising asset is recorded on Smart Online’s balance sheet. This pre-paid
      barter advertising asset is amortized to expense as advertising services are
      received such as when an advertisement runs in a magazine. Where more than
      one
      deliverable exists, such as when the barter partner is to provide advertising
      in
      four issues of a magazine, the expense is recognized pro-rata as the
      advertising deliverable is provided. Barter revenues totaled approximately
      $346,000 and $40,000, for the nine months ended June 30, 2005 and 2004,
      respectively. Barter revenues totaled approximately $113,000 for the year ended
      December 31, 2004.  Smart Online did not have any barter transactions for
      the years ended December 31, 2003 and 2002.





*Marketable
      Securities* -
      Management determines the appropriate classification of investments in
      marketable securities at the time of purchase in accordance with Statement
      of
      Financial Accounting Standards No. 115, *Accounting
      for Certain Investments in Debt and Equity Securities* and
      reevaluates such determination at each balance sheet date. Securities, which
      are
      classified as available for sale at December 31, 2004, are carried at fair
      value, with the unrealized gains and losses, net of tax, reported as a separate
      component of stockholders’ equity. Fair value is determined based on quoted
      market rates. Realized gains and losses and declines in value judged to be
      other-than-temporary on securities available for sale are included as a
      component of interest income. The cost of securities sold is based on the
      specific-identification method. Interest on securities classified as available
      for sale is also included as a component of interest income.


28
 Index





*Impairment
      of Long Lived Assets* -
      Long-lived assets and certain identifiable intangibles are reviewed for
      impairment whenever events or changes in circumstances indicate that the
      carrying amount of an asset may not be recoverable. Recoverability of assets
      to
      be held and used is measured by a comparison of the carrying amount of an asset
      to future net cash flows expected to be generated by the asset. If such assets
      are considered to be impaired, the impairment to be recognized is measured
      by
      the amount by which the carrying amount of the assets exceeds the fair value
      of
      the assets. Assets to be disposed of are reported at the lower of the carrying
      amount or fair value less costs to sell.





*Income
      Taxes.* We
      are
      required to estimate our income taxes in each of the jurisdictions in which
      we
      operate. This involves estimating our current tax liabilities in each
      jurisdiction, including the impact, if any, of additional taxes resulting from
      tax examinations as well as making judgments regarding our ability to realize
      our deferred tax assets. Such judgments can involve complex issues and may
      require an extended period to resolve. In the event we determine that we will
      not be able to realize all or part of our net deferred tax assets, an adjustment
      would be made in the period such determination is made. We recorded no income
      tax expense in any of the periods presented, as we have experienced significant
      operating losses to date. If utilized, the benefit of our total net operating
      loss carryforwards may be applied to reduce future tax expense. Since our
      utilization of these deferred tax assets is dependent on future profits, which
      are not assured, we have recorded a valuation allowance equal to the net
      deferred tax assets. These carryforwards would also be subject to limitations,
      as prescribed by applicable tax laws. As a result of prior equity financings
      and
      the equity issued in conjunction with certain acquisitions, we have incurred
      ownership changes, as defined by applicable tax laws. Accordingly, our use
      of
      the acquired net operating loss carryforwards may be limited. Further, to the
      extent that any single year loss is not utilized to the full amount of the
      limitation, such unused loss is carried over to subsequent years until the
      earlier of its utilization or the expiration of the relevant carryforward
      period.





*Impact
      of Acquisitions -* As
      more
      fully described under “Liquidity and Capital Resources - Recent Developments”,
      during October 2005, Smart Online acquired substantially all of the assets
      of
      Computility, Inc. and acquired all the stock of iMart Incorporated. Below is
      a
      summary of the major sources of income for these entities and a summary of
      the
      related revenue recognition practices.





Computility’s
      revenues are primarily derived from subscription fees, consulting revenue,
      and
      product sales.





*Computility’s
      Subscription Revenue* - Fees
      for services that are charged to customers monthly, under fixed-length
      subscription contracts. These contracts are typically three-year contracts,
      which provide enumerated services or access to Computility’s web-based products
      in exchange for a monthly subscription payment. The contract and support
      contracts are noncancelable, though they typically provide for early termination
      upon a material breach by either party that is not cured in a timely manner.
      Customers are generally invoiced monthly on the first of the month, and the
      typical payment terms provide that customers pay by automatic ACH withdrawal
      by
      the fifteenth of each month. Revenue is recognized monthly when the customers
      are invoiced for their monthly subscribed services.





*Consulting
      Revenue* - Fees
      for services to customers that are not covered by the subscription contract.
      Customers are billed for these services on an hourly basis, and Computility
      recognizes this consulting revenue at the time the customer is invoiced for
      the
      services.





*Product
      Sales* -
      Represents computer hardware and software that is sold to customers not under
      a
      subscription contract. Revenue is recognized at the time that the product is
      delivered and/or installed and the customer is invoiced for the
      product.





iMart’s
      revenues are primarily derived from subscription fees and professional
      services.





*iMart
      Subscription Fees -* Subscription based domain registration fees charged to end-users for
      registration services are recognized on a straight-line basis over the
      registration term, using a mid-month revenue recognition convention which does
      not materially differ from the use of a daily recognition method. Accordingly,
      domain name registration revenues are deferred at the time of the registration
      and are recognized ratably over the term of the registration period. A majority
      of end-user subscribers pay for services with credit cards for which the iMart
      receives remittances from the credit card associations, generally within two
      business days after the sale transaction is processed.





*iMart
      Professional Services -* Professional services and other revenues, when sold with subscription and
      support offerings, are accounted for separately when these services have value
      to the customer on a standalone basis and there is objective and reliable
      evidence of fair value of each deliverable. When accounted for separately,
      consulting revenues are recognized as the services are rendered for time and
      material contracts, and when the milestones are achieved and accepted by the
      customer for fixed price contracts. The majority of iMart’s consulting contracts
      are on a time and material basis. Training revenues are recognized after the
      services are performed.


29
 Index





In
      determining whether the consulting services can be accounted for separately
      from
      subscription and support revenues, iMart considers the following factors for
      each consulting agreement: availability of the consulting services from other
      vendors, whether objective and reliable evidence for fair value exists of the
      undelivered elements, the nature of the consulting services, the timing of
      when
      the consulting contract was signed in comparison to the subscription service
      start date, and the contractual dependence of the subscription service on the
      customer’s satisfaction with the consulting work.





The
      operating results reported below do not include any operating results from
      Computility or iMart, which acquisitions occurred during October
      2005.





**Overview
      of Results of Operations for the Quarters Ended September 30, 2005 and
      2004**





Revenue
      totaled $344,692 for the third quarter of 2005 as compared to $237,544 for
      the
      third quarter of 2004. These revenues reflect a 171 percent increase in
      integration revenues and a 105 percent increase in syndication revenues. During
      the third quarter of 2005, no revenues were derived from related parties as
      compared to $82,513 for the comparable 2004 period. Gross margin improved from
      $178,721, or 75.2 percent of revenues, during the 2004 period to $318,892,
      or
      92.5 percent of revenues, for the 2005 period primarily as a result of a
      decrease in the number of staff assigned to the customer support
      function.





Operating
      expenses increased from $1,254,341 during the third quarter of 2004 to
      $2,507,354 for the third quarter of 2005. As discussed below, the principal
      factors resulting in the increase in operating expense were (1) an increase
      of
      approximately $437,074 of consulting expenses, (2) an increase of approximately
      $40,286 in travel related expenses, (3) the inclusion of $539,051 of expenses
      associated with investors relations activities, (4) the hiring of additional
      sales staff and referral fees paid to our integration and syndication partners,
      and (5) additional programming, database management, quality assurance, and
      project management resources in the development function to support the on-going
      development of our OneBizSM Platform.





Net
      loss
      increased from $1,083,023 in the third quarter of 2004 to $2,180,856 in the
      third quarter of 2005. The above net loss equated to a loss per share of $0.17
      during the third quarter of 2005 and a loss per share of $0.12 during the third
      quarter of 2004 based on 12,832,365 and 11,089,101 weighted average shares
      outstanding, respectively.





**Overview
      of Results of Operations for the Nine Months Ended September 30, 2005 and
      2004**





Revenue
      totaled $1,004,046 for the first nine months of 2005 as compared to $723,118
      for
      the first nine months of 2004. These revenues reflect a 118 percent increase
      in
      integration revenues and a 167 percent increase in syndication revenues. During
      the first nine months of 2005, no revenues were derived from related parties
      as
      compared to $247,538 for the comparable 2004 period. Gross margin improved
      from
      $563,868, or 78 percent of revenues, during the 2004 period to $924,608, or
      92
      percent of revenues, for the 2005 primarily as a result of a decrease in stock
      based consulting expenses and a reduction in the number of staff assigned to
      the
      customer support function. During the second quarter of 2005, one integration
      agreement was cancelled resulting in the recognition of $41,250 of revenue
      that
      would otherwise have been recognized during the third quarter of
      2005.





Operating
      expenses increased from $2,866,500 during the first nine months of 2004 to
      $4,834,860 for the first nine months of 2005. As discussed below, the principal
      factors resulting in the increase in operating expense were (1) an increase
      of
      approximately $507,009 of consulting expenses associated with certain Investor
      Relations consulting agreements, an increase of approximately $76,643 in travel
      related expenses, the inclusion of $713,000 expense associated with marking
      a consultants warrants to market, and an inclusion $556,047 of expenses
      associated with allocating Investment Relations expenses, (2) the hiring of
      additional sales staff, the use of consultants to assist in the development
      and
      implementation of our sales strategy, and referral fees paid to our integration
      and syndication partners, and (3) additional programming, database management,
      quality assurance, and project management resources in the development function
      to support the on-going development of our OneBizSMPlatform.





Net
      loss
      increased from $2,375,238 in the first nine months of 2004 to $3,335,817 in
      the
      first nine months of 2005. This net loss equated to a loss per share of $0.27
      during the first nine months of 2005 and a loss per share of $0.72 during the
      first nine months of 2004 based on 12,353,443 and 11,089,101 weighted average
      shares outstanding, respectively.





The
      following tables set forth selected statements of operations data for each
      of
      the periods indicated.





30
 Index


**Revenues**





**Three
                Months Ended**
            
            
            **Nine
                Months Ended****September
                30, 2005**
            
            **September
                30, 2004**
            
            
            **September
                30, 2005**
            
            
            **September
                30, 2004**REVENUES:Integration
                fees
            
            $
            203,542
            
            $
            75,152
            
            
            $
            585,262
            
            $
            268,902Syndication
                fees
            
            
            103,602
            
            
            50,630
            
            
            
            299,244
            
            
            111,872OEM
                revenue
            
            
            12,000
            
            
            13,750
            
            
            
            36,000
            
            
            42,186Web
                services
            
            
            24,686
            
            
            14,661
            
            
            
            65,576
            
            
            49,651Other
                revenues
            
            
            862
            
            
            839
            
            
            
            17,964
            
            
            2,969Related
                party revenues
            
            
            -
            
            
            82,513
            
            
            
            -
            
            
            247,538Total
                revenues
            
            $
            344,692
            
            $
            237,545
            
            
            $
            1,004,046
            
            $
            723,118





Three
      Months Ended September 30, 2005 and 2004





Revenues
      totaled $344,692 for the third quarter of 2005 compared to $237,545 for the
      third quarter 2004 representing an increase of $107,147 or 45.1
      percent.





During
      fiscal 2004 Smart Online focused our sales efforts on entering into integration
      and syndication agreements with third parties who have significant
      small-business customer bases as we prepared for the launch of our
      OneBiz SM Platform
      during 2005. During the second half of 2005, Smart Online shifted its sales
      emphasis from signing additional integration and syndication agreements to
      preparing for the launch of its second and third versions of our
      OneBiz SM Platform.
      In connection with the rollout of the new OneBiz SM Platform
      offerings, Smart Online has begun offering potential partners volume discounted
      packages for subscription services for resale or other transfers to small
      businesses in addition to our traditional syndication opportunities. Smart
      Online has not signed any integration or syndication partners since early in
      the
      second quarter and has not signed any agreement for any partners to purchase
      volume discounted packages of subscription services. As more fully described
      under “Significant Accounting Policies”, Smart Online recognizes revenue from
      syndication and integration agreements over the expected service period of
      the
      related agreement.





During
      the third quarter of 2005, the Company gave notice of termination, effective
      October 2005, to one of its existing integration partners. As a result of this
      termination, Smart Online will recognize $37,500 in revenue during the fourth
      quarter of 2005 approximately $9,000 of which otherwise would have been
      recognized in 2006 had the agreement not terminated.





Substantially
      all of the integration and syndication revenue for the quarter ended September
      30, 2005, was derived from five integration partners and three syndication
      partners.





Substantially
      all the integration and syndication revenue for the quarter ended September
      30,
      2004, was derived from six integration partners and four syndication
      partners.





Integration
      revenues for the third quarter of 2005 totaled $203,542 as compared to $75,152
      for the same period in 2004 representing an increase of $128,390 or
      approximately 170%. Approximately 92.4 % **** of
      the
      2005 integration revenues were from three integration agreements each of which
      accounted for greater than 10% of total third quarter revenues





Syndication
      revenues for the third quarter of 2005 totaled $103,602 as compared to $50,630
      for the same period in 2004 representing an increase of $52,972 or 105%. The
      2005 revenues were derived from three syndication agreements one of which
      accounted for greater than 10% of total second quarter revenues.





Included
      in the above noted 2005 and 2004 integration and syndication revenues was
      $77,977 and $31,727 of revenue derived from barter transactions, respectively.





Web
      services and other revenues increased by $10,025 in the third quarter 2005
      as
      compared to the same period in 2004.





Smart
      Online did not derive any revenue from related parties during the third quarter
      of 2005. During the third quarter of 2004, revenues from related parties
      accounted for $82,513, or 35%, of total revenue. Management does not expect
      related party revenues to be a significant source of income going
      forward.


31
 Index





Nine
      Months Ended September 30, 2005 and 2004





Total
      revenues were $1,004,046 for the nine months ended September 30, 2005 compared
      to $723,118 for the nine months ended September 30, 2004 representing an
      increase of $280,927 or 39.0 percent.





Integration
      revenues for the nine months ended September 30, 2005 totaled $585,262 as
      compared to $268,902 for the same period in 2004 representing an increase of
      $68,822 or 13%. Approximately 43% of the 2005 integration revenues were from
      two
      integration agreements each of which accounted for greater than 10% of total
      first half 2005 revenues.





Syndication
      revenues for the nine months ended September 30, 2005 totaled $299,244 as
      compared to $111,872 for the same period in 2004 representing an increase of
      $187,372 or 167%. All of the 2005 revenues were from three syndication
      agreements each of which accounted for greater than 10% of total first half
      revenues.





Included
      in the above noted 2005 and 2004 integration and syndication revenues was
      $346,119 and $40,060 of revenue derived from barter transactions, respectively.





Web
      services revenue and other revenues increased by $15,925 and $14,995,
      respectively, for the nine months ended September 30, 2005 as compared to the
      same 2004 period.





Smart
      Online did not derive any revenue from related parties during the first nine
      months of 2005. During the first nine months of 2004, revenues from related
      parties accounted for $247,538, or 34%, of total revenue. Management does not
      expect related party revenues to be a significant source of income going
      forward.





**Cost
      of Revenues**





**Three
                Months Ended**
            
            **Nine
                Months Ended****September
                30,**
              **2005**
            
            **September
                30,**
              **2004**
            
            **September
                30,**
              **2005**
            
            **September
                30,**
              **2004**Cost
                of Revenues
            
            $
            25,800
            
            $
            58,823
            
            $
            79,438
            
            $
            159,250





Three
      months ended September 30, 2005 and 2004





Cost
      of
      revenues is comprised primarily of salaries and the cost of an external hosting
      facility associated with maintaining and supporting integration and syndication
      partners. Cost of revenues decreased 56% from $58,823 in the third quarter
      2004
      to $25,800 in the third quarter of 2005 primarily due to lower compensation
      expense. Compensation expense for the third quarter of 2005 was approximately
      82% lower than the comparable 2004 period as internal resources were reallocated
      to better match developments, sales, and customer support needs. Cost of
      revenues is expected to increase in future periods commensurate with growth
      in
      integration and syndication partners and as users are added following the 2005
      release of our OneBiz SM Platform. Additionally, Smart Online incurred approximately $12,077 of external
      hosting expense during the third quarter of 2005 as compared to $3,541 for
      the
      same period in 2004. During the third quarter of 2004, Smart Online migrated
      certain of its hosting services from its in-house operations to a third party
      that has a global reach and provides superior data hosting, data access,
      security, and back-up capabilities.





Nine
      Months Ended September 30, 2005 and 2004





Cost
      of
      revenues decreased 50% from $159,250 in the nine months ended September 30,
      2004
      to $79,438 in the nine months ended September 30, 2005 primarily due to lower
      compensation expense. As noted above in the discussion of third quarter results,
      compensation expense included in cost of revenues decreased by approximately
      82%
      as internal resources were reallocated to better match development, sales,
      and
      customer support needs.





32
 Index


**Operating
      Expenses**





**Three
                Months Ended**
            
            **Nine
                Months Ended****September
                30, 2005**
            
            **September
                30, 2004**
            
            **September
                30, 2005**
            
            **September
                30, 2004**OPERATING
                EXPENSES:General
                and administrative
            
            $
            1,761,376
            
            $
            964,614
            
            $
            3,004,574
            
            $
            2,007,121Sales
                and marketing
            
            
            374,841
            
            
            161,052
            
            
            957,519
            
            
            438,683Development
            
            
            371,137
            
            
            128,675
            
            
            872,767
            
            
            420,696Total
                operating expenses
            
            $
            2,507,354
            
            $
            1,254,341
            
            $
            4,834,860
            
            $
            2,866,500





Three
      months ended September 30, 2005 and 2004





*General
      and Administrative* -
      General
      and administrative expenses increased by $796,762 from $969,614 in the third
      quarter of 2004 to $1,761,376 in the same period of 2005 primarily as a result
      of the inclusion of $539,051 of additional expense associated with certain
      allocation of expenses with certain Investor Relations agreements. Other factors
      contributing to the increase in general and administrative expenses include
      an
      increase of approximately $437,074 in consulting expenses, an increase of
      approximately $40,286 in travel related expenses. These increases were offset
      in
      part by a decrease of approximately $77,631 in legal and professional fees.
      The
      increase in consulting fees is attributable to fees to various consultants
      engaged by the company to assist with public relations, investor relations,
      financing, and strategic planning. The increase in travel related expenses
      is
      primarily related to an increase in travel associated with investor relations
      and presentations to investor prospects.





Management
      expects that certain costs such as compliance with the Sarbanes-Oxley Act and
      other public company-related expenses including investor relations, public
      relations, shareholder related expenses and insurance will increase general
      and
      administrative expenses during the remaining fiscal 2005 as compared to the
      2004
      period. Smart Online is also shifting from dependence on outside consultants
      to
      Smart Online employees. In June 2005, Smart Online hired a General Counsel.
      Additionally, in the third quarter of 2005, Smart Online engaged a search firm
      to assist the company in a search for a Chief Financial Officer with public
      company experience.





*Sales
      and Marketing*- Sales and marketing increased from $161,052 the third
      quarter of 2004 to $374,841 in the third quarter of 2005, an increase of
      approximately $213,789. This increase in sales and marketing expense was
      primarily attributable to the hiring of additional sales personnel and higher
      recruiting and travel expenses associated with these new hires, the engagement
      of consultants, and fees due to integration and syndication partners for driving
      subscribers to our site. During the third quarter of 2005, Smart Online added
      three new sales people, including a Vice President of Marketing, and placed
      three temporary workers, with an expense of $17,562, to assist with the roll
      out
      of the OneBizSM Platform product. Additionally, during the quarter
      Smart Online engaged the services of consultants to assist with the development
      and implementation of its sales and marketing strategy and to assist the company
      with syndication and integration prospects. During October 2005, Smart Online
      also hired a Vice President of Sales. These additional sales resources will
      result in higher salary related expense in the last quarters of 2005. The 2005
      period also includes approximately $4808 of fees paid to integration and
      syndication partners, which fees are based on percentages of the subscription
      and ala carte revenue we generated from customers referred by our integration
      and syndication partners.





Generally,
      we expect we will have to increase marketing and sales expenses before we can
      substantially increase our revenue from sales of subscriptions. We plan to
      invest heavily in marketing and sales by increasing the number of direct sales
      personnel, including 5 to 10 people during the fourth quarter of 2005, expanding
      our selling and marketing activities and building brand awareness. This increase
      is being timed to coincide with the release of the second version the
      OneBizSM Platform in November 2005.





*Development*- Development expense increased from $128,675 in the third quarter of
      2004
      to $371,137 in the third quarter of 2005. The increase in development expenses
      was primarily attributable to the hiring of additional programming, database
      management, quality assurance, and project management resources to support
      the
      on-going development of the OneBizSMPlatform.




Smart
      Online expects development expenses to increase by
      approximately $200,000 during the fourth quarter of 2005 as
      compared to the third quarter of 2005 as a result of anticipated hiring of
      additional development, database management, and project management resources
      including development staff acquired in the Computility and iMart
      acquisitions.




As
      previously noted, during the third quarter of
      2005, Smart Online acquired rights to certain customized accounting
      software.  Had Smart Online not acquired this software, development expense
      during the third and fourth quarters of 2005 would be higher.




33
 Index





Nine
      Months Ended September 30, 2005 and 2004





*General
      and Administrative* -
      General
      and administrative expenses increased by $997,453 from $2,007,121 for the nine
      months ended September 30, 2004 to $3,004,574 for the same period of 2005.
      As
      noted in the discussion of third quarter results, this increase was primarily
      as
      a result of the inclusion of $556,047 of additional expense associated with
      certain investor relation activities. Other factors contributing to the increase
      in general and administrative expenses include an increase of approximately
      $507,009 in consulting expenses and an increase of approximately $76,643 in
      travel related expenses. These increases were offset in part by a decrease
      of
      approximately $123,130 in legal and professional fees. The increase in
      consulting fees is attributable to fees to various consultants engaged by the
      company to assist with public relations, investor relations, financing, and
      strategic planning. The increase in travel related expenses is primarily related
      to an increase in travel associated with investor relations and presentations
      to
      investor prospects.





*Sales
      and Marketing* -
      Sales
      and marketing increased from $438,683 in the nine months ended September 30,
      2004 to $957,519 in the nine months ended September 30, 2005, an increase of
      approximately $518,836. The first half 2005 increase was primarily attributable
      to increased advertising, consulting fees, and additional sales staff. The
      increase in advertising expense is primarily attributable to barter advertising
      expense, which increased by approximately $140,000 during the first nine months
      of 2005, as compared to the first nine months of 2004. Consulting fees increased
      by approximately $85,307 due to the engagement of consultants to assist the
      company with its development and implementation of its sales and marketing
      strategy and to assist the company with syndication and integration prospects.
      Staff related expenses, including new hires, compensation adjustments, and
      recruiting expenses, increased approximately $137,864 for the nine months ended
      September 30, 2005 as compared to the comparable 2004 period. These sales hires
      will increase the salary related expenses in the last two quarters of
      2005.





Generally,
      we expect we will have to increase marketing and sales expenses before we can
      substantially increase our revenue from sales of subscriptions. We plan to
      invest heavily in marketing and sales by increasing the number of direct sales
      personnel, including 5 to 10 people during the fourth quarter of 2005, expanding
      our selling and marketing activities and building brand awareness. This increase
      is being timed to coincide with the release of the second version of the
      OneBiz SM Platform
      in November 2005.





*Development*- Development expense increased from $420,696 in the nine months ended
      September 30, 2004 to $872,767 in the nine months ended September 30, 2005.
      This
      increase is primarily the result of Smart Online adding additional programming,
      database management, quality assurance, and project management resources to
      support the on-going development of the OneBizSMPlatform.





Smart
      Online expects development expenses in the fourth quarter of 2005 to be
      significantly higher as compared to the same period in 2004 as a result
      of additional development, database management, and project management
      resources and the impact of the recent acquisitions.





**Other
      Income (Expense)**





**Three
                Months Ended**
            
            **Nine
                Months Ended****September
                30, 2005**
            
            **September
                30, 2004**
            
            **September
                30, 2005**
            
            **September
                30, 2004**OTHER
                INCOME (EXPENSE):Interest
                income (expense), net
            
            $
            7,606
            
            $
            (7,404
            )
            $
            17,801
            
            $
            (122,001
            )Gain
                on debt forgiveness
            
            
            -
            
            
            -
            
            
            556,634
            
            
            49,395Total
                other income (expense)
            
            $
            7,606
            
            $
            (7,404
            )
            $
            574,435
            
            $
            (72,606
            )





Three
      months end September 30, 2005 and 2004





Smart
      Online earned net interest income of $7,606 during the third quarter of 2005
      and
      incurred net interest expense of $7,404 for the third quarter of 2004.





Nine
      Months Ended September 30, 2005 and 2004





Smart
      Online had net interest income of $17,801 for the first nine months of 2005
      as
      compared to net interest expense of $122,001 for the comparable 2004 period.
      The
      2004 interest expense amounts included $75,000 of interest related to the
      issuance of 150,000 shares of common stock to a relative of one of Smart
      Online’s officers in consideration for extending the term of a loan and loaning
      additional funds to the corporation. The remainder of the 2004 interest expense
      is primarily attributable to interest due on deferred compensation owed to
      officers of Smart Online and interest related to unpaid payroll tax obligations.
      Both the deferred compensation and income tax obligations were relieved during
      the first quarter of 2005. Therefore, management expects that interest expense
      will continue to be significantly lower for the remainder of
      2005.


34
 Index


During
      the first nine months of 2005, Smart Online realized gains of $556,634 as
      compared to $49,395 during the first nine months of 2004, from negotiated and
      contractual releases of outstanding liabilities. The gains from debt forgiveness
      resulted from unrelated third parties. The gain during first nine months of
      2005
      resulted primarily from a settlement of Internal Revenue Service claims for
      penalty and interest. During the first nine months of 2004, the gain resulted
      primarily from trade creditors who had performed services for Smart Online,
      agreeing to accept as payment in full a lesser amount than the stated liability
      in consideration for timely payment of the negotiated settlement. Smart Online
      does not expect gains from debt forgiveness to be material in future
      periods.





**Provision
      for Income Taxes**





We
      have
      not recorded a provision for income tax expense because we have been generating
      net losses. Furthermore, we have not recorded an income tax benefit for the
      first nine months of 2005 or fiscal 2004 primarily due to continued substantial
      uncertainty regarding our ability to realize our deferred tax assets. Based
      upon
      available objective evidence, there has been sufficient uncertainty regarding
      the ability to realize our deferred tax assets, which warrants a full valuation
      allowance in our financial statements. Smart Online has approximately
      $30,000,000 in net operating loss carryforwards, which may be utilized to offset
      future taxable income.





Utilization
      of the Company’s net operating loss carryforwards may be subject to substantial
      annual limitation due to the ownership change limitations provided by the
      Internal Revenue Code and similar state provisions. Such an annual limitation
      could result in the expiration of the net operating loss carryforwards before
      utilization.





**Liquidity
      and Capital Resources**





At
      September 30, 2005, our principal sources of liquidity were cash and cash
      equivalents totaling $3,959,300 and accounts receivable of $49,906. We do not
      have a bank line of credit.





At
      September 30, 2005, we had working capital of approximately $3.5 million. As
      a
      result of the 2005 cash infusion from the stock sales described below, payment
      of the deferred compensation and accrued interest, settlement of various claims
      and lawsuits, and based upon current cash-on-hand and contracts signed to date,
      management of Smart Online believes the Company has funds sufficient working
      capital to fund operations through April 2006. Management is actively evaluating
      additional financing options through existing and new shareholders for 2006,
      signing additional syndication partners, signing additional integration
      partners, and growing its base of subscription customers. Our working capital
      is
      not sufficient to fund our operations beyond April 2006, unless we substantially
      increase our revenue, limit expenses or raise substantial additional
      capital.





**Sales
      of Securities.** Our
      primary source of liquidity during 2004 and the first nine months of 2005 was
      from the sale of our securities. Restrictions on resale of over nine million
      shares of our Common Stock began to terminate on October 1, 2005 resulting
      in
      increased volume of resales. The release of additional restrictions may
      adversely affect the market value of our Common Stock and may make it more
      difficult to raise capital.  See “Risk Factor” Number (53) for information
      about lock-up agreements and other restrictions on resale.  During the
      first nine months of 2005, Smart Online generated net cash from financing
      activities, including the sales of common stock, of approximately $8.2 million.
      During the same period Smart Online consumed approximately $4.6 million of
      cash
      in operations, including payment of $1,126,485 related to outstanding payroll
      tax liabilities.





During
      the third quarter of 2005, Smart Online sold 786,642 shares of its common stock
      to investors for a price of $5.50 per share resulting in gross proceeds of
      $4,326,531. Smart Online incurred issuance costs totaling $232,425 related
      to
      these stock sales. Additionally, in connection with these offerings, Smart
      Online entered into Registration Rights Agreements with these shareholders
      under
      which Smart Online has agreed to filed with the SEC a registration statement
      on
      Form S-1 to register the shares sold in the offering; we expect to file the
      Form
      S-1 prior to November 30, 2005.




Also
      during the third quarter of 2005, holders of warrants to purchase 355,428 shares
      of Common Stock exercised their warrants, including 28,472 shares issued as
      a
      result of a cashless warrant exercise, resulting in gross proceeds to Smart
      Online of $1,175,998. Smart Online incurred issuance costs totaling $108,100
      related to these warrant exercises.  The warrants had exercise prices that
      ranged from $1.30 to $5.00 per share.





During
      the first nine months of 2005, Smart Online raised a total of $8.2 million
      proceeds, net of stock issuance costs of $630,525, from the sale of additional
      shares of Common Stock and the exercise of warrants to purchase shares of Common
      Stock. Approximately $1.1 million of the proceeds were used in the first quarter
      of 2005 to pay deferred compensation to our officers and related accrued
      interest amounts. Additionally, during February 2005, Smart Online reached
      a
      settlement with the Internal Revenue Service, paid $26,100, surrendered all
      credits and refunds for 2005 or earlier tax periods, and agreed to remain in
      compliance with all federal tax obligations for a term of five years to resolve
      all outstanding federal tax issues.


35
 Index


**Deferred
      Revenue.** At
      September 30, 2005 Smart Online had deferred revenue totaling $361,722, net
      of
      offsetting amounts receivable. Deferred revenue represents amounts collected
      in
      advance of the revenue being recognized. Based upon current conditions, Smart
      Online expects that approximately 60% of this amount will be recognized during
      the fourth quarter of 2005 with the remainder expected to be recognized during
      2006.





**Investor
      Relations Expenses.** In
      October 2005 Smart Online entered into agreements with two foreign firms to
      provide investor relations services. In connection with these agreements, Smart
      Online paid each of the investor relations firms $250,000 and issued
      each of the firms 625,000 shares of our Common Stock. In addition to
      recording the $500,000 of investor relations expenses for the cash portion
      of
      the investor relations fee, we expect to incur non-cash expenses equal to the
      fair market value of the shares.


**Going
      Concern.** Our
      auditors have issued an explanatory paragraph in their report included in our
      Form 10-K for the year ended December 31, 2004 in which they express substantial
      doubt as to our ability to continue as a going concern. The financial statements
      do not include any adjustments relating to the recoverability and classification
      of recorded asset amounts or the amounts or classification of liabilities that
      might be necessary should Smart Online be unable to continue as a going concern.
      Smart Online’s continuation as a going concern is dependent upon its ability to
      generate sufficient cash flows to meets its obligations on a timely basis,
      to
      obtain additional financing as may be required and ultimately to attain
      profitable operations and positive cash flows. As is discussed below, management
      has plans which it believes will enable Smart Online to raise capital and
      generate greater cash flows from operations. However, there can be no assurance
      that these efforts will be successful. If our efforts are unsuccessful, we
      may
      have to cease operations and liquidate our business.





**Recent
      Developments.** During
      August 2005, Smart Online entered into a software assignment and development
      agreement with the developer of a customized accounting software application
      that provides for the assignment and customization of certain accounting
      application software. The initial integration of this product into the
      OneBiz SM Platform
      was completed in September 2005 with the remainder planned for December
      2005. In connection with this agreement, Smart Online agreed to pay the
      developer up to $512,500 and issue up to $287,500 worth of Smart Online Common
      Stock based upon the developer attaining certain milestones. As of September
      30,
      2005, Smart Online the developer had earned and been paid $105,000 ($90,000
      in
      cash and $15,000 of company stock). In accordance with SFAS No. 86, *Accounting
      for the Costs of Computer Software to be Sold, Leased, or Otherwise
      Marketed* ,
      Smart
      Online has capitalized these costs. The remaining portion of the software
      assignment and development fees is expected to be earned and payable during
      the
      fourth quarter of 2005 and the first quarter of 2006.





During
      October 2005, Smart Online acquired substantially all of the assets of
      Computility, Inc., a privately held developer and distributor of customer
      relationship management software based in Des Moines, Iowa. In consideration
      for
      the purchased assets, Smart Online issued the seller 484,213 shares of our
      Common Stock and assumed certain liabilities of Computility totaling
      approximately $1.9 million. In addition two key employees of Computility can
      earn up to a total of $91,800 each over and above their base compensation during
      the fifteen months ended December 31, 2006, if certain performance goals are
      achieved. Historically, Computility derived substantially all of its revenue
      from software and hardware subscription agreements which typically have 3-year
      terms with substantial penalties for early termination. Until the date of the
      acquisition, Computility factored substantially all of its subscription
      agreements and received approximately 65% of the expected cash flow from the
      subscription period upfront and used the cash to fund on-going operations.
      As a
      result of the factor arrangements, Smart Online will be required to provide
      services to the customers, but will only receive approximately 35% of the
      corresponding customer payments As a result of factoring activity of
      Computility, and based on contracts signed as of the date of acquisition,
      management expects that the acquisition will result in an approximate $100,000
      monthly increase in cash expenditures for the remainder of 2005 and begin to
      decrease modestly throughout 2006.





Also
      during October 2005, Smart Online acquired all the stock of iMart Incorporated,
      a privately held developer and distributor of multi-channel e-commerce systems
      based in the Great Lakes region of the United States. Smart Online will pay
      iMart’s stockholders $3,366,000 in cash and 205,767 shares of our Common Stock.
      The cash is payable in four equal payments of $420,750 on the first business
      day
      of each of January 2006, April 2006, July 2006 and October 2006. The remaining
      $1,683,000 is payable in January 2007. In addition, Smart Online is to pay
      $780,000 for noncompetition agreements to key personnel of the acquired company
      in eight equal quarterly installments during the period beginning in January
      2006 and ending October in 2007. The cash payments are to be secured by the
      net
      proceeds of customer contracts of iMart, which will limit our ability to use
      iMart revenue in our business until all cash is paid to iMart shareholders
      and
      employees. Smart Online does not currently have sufficient cash to fund the
      purchase obligations and there can be no assurance that Smart Online will be
      able to fund the commitments it made in this acquisition. See Note 7 to the
      Notes to Financial Statements for more information about the iMart
      acquisition.


36
 Index





The
      effect of the Computility acquisition and the iMart acquisition on the cash
      resources and needs of Smart Online is not known at this time and will not
      be
      known until Smart Online develops a history of operating the acquired entities.
      However, substantial expenses were incurred in professional fees in connection
      with these transactions, and it is anticipated that substantial amounts will
      be
      incurred in integrating the acquired companies into Smart Online. Management
      believes that the acquisitions will initially result in greater working capital
      needs as we expect Smart Online will not acquire substantial accounts
      receivables. Management believes these acquisitions will eventually result
      in
      positive cash flow to Smart Online, but the initial effect on Smart Online’s
      working capital will be negative. The acquisitions present both opportunities
      and risks for Smart Online. See “Risk Factors” Numbers (13) and (14) for
      discussion of certain risks associated with the acquisitions.





**Anticipated
      Increases in Expenses to Fund Growth In Revenue.** With
      the
      release of our OneBiz SM Platform
      and the expenses associated with becoming a public company, we believe our
      capital requirements in 2005 and beyond will be greater than in past years.
      As
      such, our historical cash flows may not be indicative of future cash flows.
      The
      following is a discussion of factors that we consider important to our future
      capital requirements and which will affect the amount of additional capital
      we
      need to raise.





Our
      future capital requirements will depend on many factors, including our rate
      of
      revenue growth, the expansion of our marketing and sales activities, the timing
      and extent of spending to support product development efforts and expansion
      into
      new territories, the timing of introductions of new services and enhancements
      to
      existing services, the effect of the contemplated acquisitions as described
      above, and the market acceptance of our services.





Primary
      drivers for future operating cash flows include the commercial success of our
      existing services and products and the timing and success of any new services
      and products and our ability to maintain and grow the revenues from the
      companies we acquired. Smart Online will continue to seek additional integration
      and syndication customers who typically pay an upfront fee and to increase
      revenues generated from small business end users.





**Integration,
      Syndication and Other Contracts.** Upfront
      payments totaling approximately $100,000, primarily related to new integration
      and syndication contracts, positively impacted operating cash flows for the
      nine
      months ended September 30, 2005. No new syndication or integration contracts
      have been signed since April 2005. As we release our OneBiz SM Platform, we are shifting our efforts away from up-front integration and
      syndication fees to utilize our syndication arrangements to generate
      subscription revenue from subscription sales to small businesses and sales
      of
      volume discounted subscriptions to our partners.





**Receivables.** If
      we are
      successful in signing new contracts, we anticipate our receivables and
      collections from integration, syndication, and end-user licensing opportunities
      to increase significantly starting during the first quarter of 2006. Smart
      Online’s receivables are primarily from major companies or banking institutes,
      and not end users. Management has evaluated the need for an allowance for
      doubtful accounts and determined that no provision for uncollectible accounts
      is
      required as of September 30, 2005 and December 31, 2004.





**Facilities.** Smart
      Online’s principal administrative, sales, marketing, and research and
      development facility is located in Durham, North Carolina and consists of over
      5,000 square feet of office space. The facility, which is fully furnished,
      is
      subject to a lease agreement that expires on October 31, 2006 .
      During
      the first half of 2006, Smart Online will evaluate its options with regard
      to
      extending its current lease and relocating to new facilities. Should management
      determine that it is in Smart Online’s best interest to relocate, Smart Online
      will likely incur significant additional costs associated with relocating its
      operations and furnishing the new space. In addition, Smart Online will also
      operate from the current office of Computility in Iowa and the current office
      of
      iMart in Michigan.




**Media
      and Barter Transactions.** Smart
      Online expects to create arrangements in the future with media companies who
      offer the ability to reach small business customers and will assist in
      off-setting Smart Online’s outlay of cash for more costly print and online
      advertising and marketing. While we intend to derive a majority of our
      syndication revenue from traditional non-barter transactions, we will evaluate
      barter transactions on a case-by-case basis when we believe such transactions
      make economic or strategic sense.





**End
      User Customer Revenue.** Until
      recently we allowed most of our web-based products to be used without charge.
      This gained us users, but limited our revenue. We recently changed our free
      use
      policy and began to sell subscriptions. However, there can be no assurance
      that
      we will be successful in attracting new customers or that customers will pay
      for
      our products. We also recently began to offer to our syndication partners value
      discounts for pre-paid subscriptions, which they can either resell or contribute
      to their small business customers. Our changes to our subscription policies
      are
      too recent for us to determine how they will affect our
      revenues.


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**Marketing
      and Sales Expense Increases** .
      Generally, we expect we will have to increase marketing and sales expenses
      before we can substantially increase our revenue from sales of subscriptions.
      We
      plan to invest heavily in marketing and sales by increasing the number of direct
      sales personnel, including 5 to 10 people during the fourth quarter of 2005,
      expanding our selling and marketing activities and building brand awareness.
      This increase is being timed to coincide with the release of the second version
      the OneBiz SM Platform
      in November 2005.





**Gains
      From Debt Forgiveness.** During
      the first nine months of 2005 and 2004 Smart Online realized gains totaling
      $556,634 and
      $49,395, respectively, resulting from negotiated and contractual releases of
      outstanding liabilities. The 2005 gain was primarily from the settlement with
      the Internal Revenue Service. The 2004 gains were primarily related to unrelated
      third parties, primarily trade creditors who had performed services for Smart
      Online, agreeing to accept as payment in full a lesser amount than the stated
      liability in consideration for timely payment of the negotiated settlement.
      Had
      Smart Online not been able to reach agreement with the Internal Revenue Service
      and these creditors, Smart Online’s liabilities and future cash flow
      requirements would have been higher by the amount of the debt
      forgiven.





**Public
      Company Expenses.** As
      a
      public company, we will incur significant legal, accounting and other expenses
      that we did not incur as a private company. We will incur costs associated
      with
      our public company reporting requirements. We also anticipate that we will
      incur
      costs associated with recently adopted corporate governance requirements,
      including requirements under the Sarbanes-Oxley Act of 2002, as well as new
      rules implemented by the Securities and Exchange Commission, the NASD, and
      national securities exchanges. We expect these rules and regulations to increase
      our legal and financial compliance costs and to make some activities more
      time-consuming and costly. Any unanticipated difficulties in preparing for
      and
      implementing these reforms could result in material delays in complying with
      these new laws and regulations or significantly increase our costs. Our ability
      to fully comply with these new laws and regulations is also uncertain. Our
      failure to timely prepare for and implement the reforms required by these new
      laws and regulations could significantly harm our business, operating results,
      and financial condition. We are currently evaluating and monitoring developments
      with respect to these new rules, and we cannot predict or estimate the amount
      of
      additional costs we may incur or the timing of such costs. We estimate this
      will
      add approximately $500,000 to our expenses during 2005, our first year as a
      public company.





**Legal
      Claims.** Smart
      Online is subject to other claims and suits that arise from time to time in
      the
      ordinary course of business. While management currently believes that resolving
      these matters, individually or in aggregate, will not have a material adverse
      impact on Smart Online’s financial position or results of operations, the
      litigation and other claims noted above are subject to inherent uncertainties
      and management’s view of these matters may change in the future. In the event an
      unfavorable final outcome were to occur, there exists the possibility of a
      material adverse impact on Smart Online’s financial position and the results of
      operations for the period in which the effect becomes reasonably estimable.
      See
“Part II - Item 1.Legal Proceedings” for a description of current
      litigation.





**RISK
      FACTORS**




An
      investment in Smart Online involves significant risks. You should read the
      risks
      described below very carefully before deciding whether to invest in Smart
      Online. The following is a description of what we consider our key challenges
      and risks.




We
      operate in a dynamic and rapidly changing business environment that involves
      substantial risk and uncertainty and these risks may change over time. The
      following discussion addresses some of the risks and uncertainties that could
      cause, or contribute to causing, actual results to differ materially from
      expectations. In evaluating our business, readers should pay particular
      attention to the descriptions of risks and uncertainties described below and
      in
      other sections of this document and our other filings with the Securities and
      Exchange Commission.




**We
      have organized these factors into the following categories
      below:**




·
            Our
                Financial Condition





·
            Our
                Products and Operations





·
            Our
                Market, Customers and Partners





·
            Our
                Officers, Directors, Employees and
                Shareholders





·
            Regulatory
                Matters that Affect Our Business





·
            Matters
                Related to the Market For Our
                Securities


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**RISKS
      ASSOCIATED WITH OUR FINANCIAL CONDITION**







**(1)
      We Have Had Recurring Losses From Operations Since Inception, and Have
      Deficiencies in Working Capital and Equity Capital. If We Do Not Rectify These
      Deficiencies, We May Have to Cease Operations and Liquidate Our Business.
      Because We Have Only Nominal Tangible Assets, You May Lose Your Entire
      Investment.**





Through
      September 30, 2005, we have lost an aggregate of approximately $40.1 million
      since inception on August 10, 1993. During the nine months ended September
      30,
      2005 and the year ended December 31, 2004, we suffered a net loss of
      approximately $3.3 million and $2.9 million, respectively. At June 30, 2005,
      we
      had a $3.5 million working capital surplus. Our working capital is not
      sufficient to fund our operations for the next year, unless we substantially
      increase our revenue, limit expenses or raise substantial additional capital.
      Because we have only nominal tangible assets, you may lose your entire
      investment.





**(2)
      Our Independent Registered Public Accountants Have Indicated That They Have
      Substantial Doubts That Smart Online Can Continue as a Going Concern. Our
      Independent Registered Public Accountants’ Opinion May Negatively Affect Our
      Ability to Raise Additional Funds, Among Other Things. If We Fail to Raise
      Sufficient Capital, We Will Not Be Able to Implement Our Business Plan, We
      May
      Have To Liquidate Our Business and You May Lose Your
      Investment.**





BDO
      Seidman, LLP, our independent registered public accountants, has expressed
      substantial doubt, in their report included in our Form 10-K for the year ended
      December 31, 2004, about our ability to continue as a going concern given our
      recurring losses from operations and deficiencies in working capital and equity,
      which are described in the first risk factor above. This opinion could
      materially limit our ability to raise additional funds by issuing new debt
      or
      equity securities or otherwise. If we fail to raise sufficient capital, we
      will
      not be able to implement our business plan, we may have to liquidate our
      business and you may lose your investment. You should consider our independent
      registered public accountants’ comments when determining if an investment in
      Smart Online is suitable.





**(3)
      We Will Require Additional Financing To Fund Our Operations Or Growth. If
      Financing Is Not Available, We May Have To Liquidate Our Business and You May
      Lose Your Investment.**





In
      the
      future, we will be required to seek additional financing to fund our operations
      or growth. Factors such as the commercial success of our existing services
      and
      products, the timing and success of any new services and products, the progress
      of our research and development efforts, our results of operations, the status
      of competitive services and products, and the timing and success of potential
      strategic alliances or potential opportunities to acquire technologies or assets
      may require us to seek additional funding sooner than we expect. We cannot
      assure you that such funding will be available. If sufficient capital is not
      raised, our ability to achieve or sustain positive cash flows, maintain current
      operations, fund any potential growth, take advantage of unanticipated
      opportunities, develop or enhance services or products, or otherwise respond
      to
      competitive pressures would be significantly limited. If we fail to raise
      sufficient capital, we will not be able to implement our business plan, we
      may
      have to liquidate our business and you may lose your investment **.** Restrictions
      on resale of over nine million shares of our Common Stock terminated on October
      1, 2005, and the volume of resales may adversely affect the market value of
      our
      Common Stock and may make it more difficult to raise capital. See Risk Factor
      (53) for information about lock-up agreements and other restrictions on
      resale.





**(4)
      If We Are Able To Raise Capital, But Are Not Able To Obtain Terms That are
      Favorable To Us, Existing Shareholders and New Investors May Suffer Dilution
      Of
      Their Ownership Interests in Our Company Or Otherwise Lose Value In Our
      Securities.**





If
      we
      raise additional funds through the issuance of equity securities or debt
      convertible into equity securities, the percentage of stock ownership by our
      existing stockholders would be reduced. In addition, such securities could
      have
      rights preferences and privileges senior to those of our current stockholders
      and new investors in this offering, which could substantially decrease the
      value
      of our securities owned by them.




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**RISKS
      ASSOCIATED WITH OUR PRODUCTS AND OPERATIONS**





**(5)
      We Will Rely Heavily On Successful Development and Market Acceptance of Our
      OneBiz** **SM** **Platform**





Since
      2000, we have generated substantially all of our revenues from our current
      Internet-based services, content and software applications. Internet-based
      products are growing in sophistication and customer expectations are rising
      as
      new products are introduced. During the first quarter of 2005, we released
      the
      first version of our OneBiz SM Platform. The second version of our OneBiz SM Platform
      was recently released, but we do not expect to see substantial revenue increases
      until after we release and have time to sell the third installment of the
      OneBiz SM Platform, which is scheduled to occur before the end of 2005. Our future
      financial performance and revenue growth will depend upon the successful
      development, introduction, and customer acceptance of the OneBiz SM Platform.





**(6)
      We May Not Successfully Develop or Introduce the Next Installment of Our Next
      Generation Product, Our OneBiz** **SM** **Platform, and Other New Products or Enhancements to Existing Products, Which
      Could Harm Our Business.**





Our
      future financial performance and revenue growth will depend, in part, upon
      the
      successful development, introduction, and customer acceptance of our next
      generation product, our OneBiz SM Platform. Thereafter other new products and enhanced versions of our web-native
      business applications will be critically important to our business. Our business
      could be harmed if we fail to deliver enhancements to our current and future
      solutions that our customers desire. From time to time, we have experienced
      delays in the planned release dates of our software (including our
      OneBiz SM Platform) and upgrades, and we have discovered software defects in new releases
      both before and after their introduction. New product versions or upgrades
      may
      not be released according to schedule, or may contain certain defects when
      released. Either situation could result in adverse publicity, loss of sales,
      delay in market acceptance of our services and products, or customer claims
      against us, any of which could harm our business. If we do not deliver new
      product versions, upgrades, or other enhancements to existing services and
      products on a timely and cost-effective basis, our business will be harmed.
      We
      are also continually seeking to develop new offerings. However, we remain
      subject to all of the risks inherent in product development, including
      unanticipated technical or other development problems, which could result in
      material delays in product introduction and acceptance or significantly
      increased costs. There can be no assurance that we will be able to successfully
      develop new services or products, or to introduce in a timely manner and gain
      acceptance of such new services or products in the marketplace. The second
      version of the OneBiz SM Platform
      was recently released. The third version of the OneBiz SM Platform, including enhanced accounting software, is expected to be released
      before the end of 2005. Smart
      Online is evaluating its development priorities in light of its recent
      acquisition of Computility and iMart and expects that some previously featured
      parts of the third version may be modified, delayed, or eliminated in light
      of new development priorities. In that regard, the following features contained
      in the third version, as previously disclosed, may not be released on or before
      December 31, 2005: Dashboard,
      detail drill-down views & capabilities; Dashboard, dynamically update OneBiz
      funcionality based on state of business; HR, professional training (continuing
      education); Shipping (advanced features); Printing & copying
      services.


**(7)
      We Have Experienced Delays in Developing Our Next Generation Platform, Our
      OneBiz** **SM** **Platform. Existing Factors May Result in Further Delays Which Could Harm Our
      Business.**





We
      had
      planned to release the first version of our Next Generation Platform during
      the
      fourth quarter of 2004 and the second version during the third quarter of 2005.
      Testing by some customers of the first version began at the end of 2004, but
      commercial release was delayed until the first quarter of 2005. Development
      of
      applications for the second version was completed in the third quarter of 2005,
      but bundling the application into a seamless subscription package was
      delayed until November of 2005.   In addition to the factors that may
      delay or prevent completion of any new product development project, some
      existing factors may further delay or prevent development of our next generation
      product, the OneBiz SM Platform. These factors include the following. Our OneBiz SM Platform
      requires both enhancing our existing technology platform and adding many new
      software applications. Integrating so many new applications at the same time
      is
      difficult. In addition, bundling individual applications into an attractive
      subscription package after development is complete takes time.  Another
      factor that might delay or prevent development of the OneBiz SM Platform
      is that we have to hire, train and manage new development personnel to complete
      internal development on time. In addition, for many of the most important new
      applications of the OneBiz SM Platform, such as accounting, we rely on third party sources, whether through
      licensing, joint development or purchase. The willingness of third parties
      to
      enter into agreements with us and the ability of third parties to perform
      agreements are totally outside our control. The third version of the
      OneBiz SM Platform, including enhanced accounting software, is expected to be released
      before the end of 2005.  Smart
      Online is evaluating its development priorities in light of its recent
      acquisition of Computility and iMart and expects that some previously featured
      parts of the third version may be modified, delayed, or eliminated in light
      of new development priorities. In that regard, the following features contained
      in ther third version, as previously disclosed, may not be released on or before
      December 31, 2005: Dashboard,
      detail drill-down views & capabilities; Dashboard, dynamically update OneBiz
      funcionality based on state of business; HR, professional training (continuing
      education); Shipping (advanced features); Printing & copying
      services.




Our
      business could be harmed, if we fail to deliver the improved performance that
      customers want with respect to our current and future offerings. There can
      be no
      assurance that our next generation platform will achieve widespread market
      penetration or that we will derive significant revenues from sales of the
      OneBiz SM Platform.





**(8)
      Our Products Might Not Keep Pace with Technological Change, Which Could Harm
      Our
      Business.**





We
      must
      continually modify and enhance our services and products to keep pace with
      changes in hardware and software platforms, database technology, and electronic
      commerce technical standards. As a result, uncertainties related to the timing
      and nature of new product announcements or introductions, or modifications
      by
      vendors of operating systems, back-office applications, and browsers and other
      Internet-related applications, could harm our business.


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 Index








**(9)
      Our Business Is Difficult To Evaluate Because Our Business Models and Operating
      Plans Have Changed As A Result of Forces Beyond Our Control. Consequently,
      We
      Have Not Yet Demonstrated That We Have a Successful Business Model or Operating
      Plan.**





We
      incorporated in 1993 with a CD-ROM based business model. In 1999, we
      commercially introduced our Internet-based Software-as-Service (SaS) business
      model, when it became clear that the developing Internet world offered a better
      delivery platform. We began to enter into syndication partnering arrangements
      during the year 2000 primarily as a result of the need to leverage the marketing
      and sales resources of others. Our business models and operating plans have
      evolved as a result of changes in our market, the expectations of customers
      and
      the behavior of competitors. Today, we anticipate that our future financial
      performance and revenue growth will depend, in large part, upon our
      Internet-based SaS business model and syndication partnering arrangements,
      but
      these business models may again become ineffective due to forces beyond our
      control that we do not currently anticipate. Consequently, we have not yet
      demonstrated that we have a successful business model or operating plan. Our
      evolving business model makes our business operations and prospects difficult
      to
      evaluate. Investors in our securities should consider all the risks and
      uncertainties that are commonly encountered by companies in this stage of
      business operations, particularly companies, such as ours, that are in emerging
      and rapidly evolving markets.





**(10)
      It Is Important For Us To Continue To Manage Changing Business Conditions.
      Failure To Do So Could Harm Our Business.**





Our
      future operating results will depend, in part, on our ability to manage changing
      business conditions, including such conditions as the general economic slowdown,
      reduced investment in information technology by customers and prospective
      customers, and reduced business travel and entertainment budgets. If we are
      unable to manage changing business conditions effectively, our
      business, financial condition, and results of operations could be
      materially and adversely affected. Failure to manage our operations with reduced
      staffing levels may strain our management, financial, legal, and other
      resources, and could have a material adverse effect on our business, financial
      condition, and results of operations.





**(11)
      The Success of Our Business Depends on The Continued Growth and Acceptance
      of
      the Internet as a Business Tool. If These Positive Trends Do Not Continue To
      Develop, Our Business Could Be Harmed.**





Expansion
      in the sales of our service depends on the continued growth and acceptance
      of
      the Internet as a communications and commerce platform for enterprises. The
      Internet could lose its viability as a business tool due to delays in the
      development or adoption of new standards and protocols to handle increased
      demands of Internet activity, security, reliability, cost, ease-of-use,
      accessibility and quality-of-service. The performance of the Internet and its
      acceptance as a business tool has been harmed by “viruses,” “worms” and
      similar malicious programs, and the Internet has experienced a variety of
      outages and other delays as a result of damage to portions of its
      infrastructure. If for any reason the Internet does not remain a widespread
      communications medium and commercial platform, the demand for our service would
      be significantly reduced, which would harm our business.





**(12)
      We Sell Third-Party Software and Web Services That May be Difficult to Replace.
      If We Are Not Able to Replace Third Party Software And Web Services, Our
      Business May Be Harmed.**





We
      rely
      on software licensed from third parties to offer some of our services and
      software offerings, including merchant services, incorporation services, on-line
      direct mail services and loan referrals. During 2004, approximately 6% of our
      revenue was derived from such third party software and services. During 2003
      and
      2002 approximately 16% and 17%, respectively, of our revenue was derived from
      such sources. These software and services may not continue to be available
      on
      commercially reasonable terms, if at all. The loss or inability to maintain
      any
      of these arrangements could result in delays in the sale of our services or
      software offerings until equivalent technology or services are either developed
      by us, or, if available, are identified, licensed, and integrated. Any such
      delay could harm our business.





**(13)
      We Have Acquired Certain Products and We Recently Purchased Two Other Companies.
      We May Acquire Other Companies in the Future. We Face Risks Associated with
      Those Acquisitions. These Risks Include, But Are Not Limited to, Difficulty
      of
      Integrating, Dilution of Stockholder Value and Disruption of Our Business,
      Which
      Could Adversely Affect Our Operating Results.**





During
      August 2005 we acquired nonexclusive rights to certain accounting application
      software. Additionally, as discussed below, in October 2005 we acquired two
      software companies. In the future, we plan to acquire other products or
      technologies. We may not realize the anticipated benefits of our current or
      future acquisitions or investments to the extent that we anticipate, or at
      all.  We may have to issue debt or issue equity securities to pay for
      future acquisitions or investments, the issuance of which could be dilutive
      to
      our existing stockholders and investors in this offering. If any acquisition
      or
      investment is not perceived as improving our earnings per


41
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share,
      our stock price may decline. In addition, we may incur non-cash amortization
      charges from acquisitions, which could harm our operating results. Any completed
      acquisitions would also require significant integration efforts, diverting
      our
      attention from our business operations and strategy. We have made limited
      acquisitions to date, and therefore our ability as an organization to make
      acquisitions or investments is unproven. Acquisitions and investments involve
      numerous risks, including:





·   difficulties
      in integrating operations, technologies, services and personnel;


·   diversion
      of financial and managerial resources from existing operations;


·   risk
      of
      entering new markets;


·   potential
      write-offs of acquired assets;


·   potential
      loss of key employees;


·   inability
      to generate sufficient revenue to offset acquisition or investment costs;
      and


·   delays
      in
      customer purchases due to uncertainty.





In
      addition, if we finance future acquisitions by issuing convertible debt or
      equity securities, our existing stockholders and investors in this offering
      may
      be diluted which could affect the market price of our stock. As a result, if
      we
      fail to properly evaluate and execute acquisitions or investments, our business
      and prospects may be seriously harmed.





During
      October 2005, Smart Online acquired all the assets of Computility, Inc., a
      privately held developer and distributor of customer relationship management
      software based in Iowa. Also, during October of 2005, we
      acquired iMart Incorporated, a privately held developer and distributor of
      multi-channel commerce systems based in Michigan. In addition, the accounting
      software to be included in the OneBiz SM Platform
      is being supplied by another company. In addition to the general risks
      associated with acquisitions outlined above, there are additional risks
      associated with these two acquisitions including:





·   risk
      of
      operating and integrating geographically remote offices;


·   risk
      of
      integrating technologies and offerings with the OneBiz SM Platform;


·  risk
      of
      converting customer data from stand alone product offerings of the acquisition
      targets to formats utilized by the OneBiz SM Platform;


·  risk
      of
      losing customers of the acquired companies due to actual or perceived changes
      in
      operations and customer interfaces;


·   risk
      of
      integrating management, administrative, operational and financial
      infrastructures;


·  risks
      of
      implementing and monitoring compliance with corporate governance and public
      company reporting; and requirements and the ability of management to manage
      and
      timely and accurately consolidate the results of operations.





For
      example, approximately 89% of iMart’s revenue during year 2004 was from a group
      of related customers, the loss of which would have a material adverse affect
      on
      our business. Additional cash payments of up to $870,000 to iMart and
      Computility employees over and above their normal salaries will also drain
      our
      working capital, if sales of iMart and Computility products are less than we
      expect, or if expenses are greater than we expect.





**(14)
      Our Agreements in the Acquisition of iMart Incorporated Contain Installment
      Payments, Lock Box, License, Noncompetition and Control Provisions That Could
      Have A Material Adverse Effect on Smart Online.**





When
      Smart Online purchased iMart in October 2005, Smart Online committed to make
      installment payments of $3,366,000 and non-competition payments of $780,000.
      To
      secure the $3,366,000 of acquisition purchase price installment payments all
      the
      revenue of iMart is to be deposited in lock box with the use limited to
      specified purposes. In addition if Smart Online defaults in any payments, key
      employees of iMart will have a nonexclusive license to certain software of
      iMart, their non-competition restrictions will terminate and their
      non-solicitation and nondisclosure comments will be limited in scope. In
      addition, a key employee of iMart has received contractual rights to operate
      iMart within agreed upon financial parameters. All of these provisions are
      interrelated and pose certain risks for Smart Online. See “Note 7 to the Notes
      to Financial Statements” for a summary of these provisions of the iMart
      acquisition agreements.





Most
      of
      the consideration being paid to the iMart key employees, who were shareholders
      of iMart, is to be paid in cash in installments over a two-year period and
      the
      value of the shares of Smart Online the key employees own is substantially
      less
      than the cash payments required to be made to the key employees. Due to several
      of the acquisition contract provisions described below, conflict of interest
      situations may arise between the key employee’s personal interests and the
      interests of Smart Online’s shareholders as the key employee exercises the
      contractual authority granted to him in the acquisition agreements.  The
      acquisition agreements address conflict of interest situations and provide
      that
      until all the acquisition purchase price installment payments are made, an
      iMart
      key


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employee
      will determine what is in the best interest of iMart, Smart Online and the
      selling shareholders of iMart, but he must identify any conflicts of interest
      to
      iMart’s Chief Executive Officer, in which case iMart’s Chief Executive Officer
      (who is currently also the Chief Executive Officer of Smart Online) can make
      the
      decision with respect to which a conflict of interest exists, except that if
      the
      decision would cause iMart’s EBITDA to be substantially below $1,452,795, then
      iMart’s Chief Executive Officer can make the decision only if either the amount
      in the lock box account is at least $500,000 or Smart Online provides an
      irrevocable letter of credit or cash for payment of the remaining acquisition
      purchase price installment obligations. Smart Online would not have to provide
      the letter of credit or cash, if the decision relates to compliance with
      applicable laws, rules or regulations applicable to iMart.




Without
      agreement by the authorized people to release funds from the lock box
      account, Smart Online will be required to find other resources to pay the
      operating expenses of iMart, which we expect will exceed the $146,000 of monthly
      expenses targeted to be paid from the lock box account. Consequently, we expect
      the iMart acquisition will initially be a drain on our cash resources. If the
      authorized signatories fail to reach agreement, the lock box revenue will be
      frozen and iMart and Smart Online may be unable to pay their obligations, which
      could substantially harm their businesses.




These
      provisions of the iMart acquisition agreements described above may have a
      material adverse effect on Smart Online and present many risks for Smart Online
      and its investors. For example, lenders may refuse to extend credit because
      of
      the security interest granted to iMart’s selling shareholders or because the
      lock box release provisions may create cash flow problems for iMart and Smart
      Online. Financial parameters contained in the agreements may impair the ability
      of Smart Online to integrate iMart’s operations into the overall business
      strategy of Smart Online. Contractual decision-making ability granted to the
      key
      iMart employee may lead to disputes with officers and directors of Smart Online
      that interfere with operation of the business.  Since the key iMart
      employee established iMart’s relationships with substantially all of iMart’s
      customers and iMart does not have long-term contracts with its customers, our
      ability to retain iMart’s customers may be at substantial risk if the key
      iMart employee’s non-competition and non-solicitation restrictions are
      terminated and he obtains the license to iMart’s products.  Potential
      acquirors of Smart Online may decide not to purchase Smart Online because of
      these provisions or may substantially lower their offering price, in which
      case
      Smart Online may seek to renegotiate with the key iMart employee. The
      substantial acquisition price installments payments and non-competition payments
      required to be paid may drain Smart Online’s financial resources or Smart Online
      may fail to make such payments, which may trigger the termination of
      non-competition provisions and the grant of a license that would enable the
      key
      iMart employee to compete with iMart and Smart Online. Investors may fear that
      conflicts of interest may cause the key employee to make decisions that are
      not
      in the interest of Smart Online’s shareholders.





**(15)
      We Rely on Third-Party Hardware and Software That May Be Difficult To Replace
      or
      Which Could Cause Errors or Failures of Our Service. Such Events May Harm Our
      Business.**





We
      rely
      on hardware purchased or leased and software licensed from third parties in
      order to offer our service. We use commercially available hardware and software
      from vendors like Oracle, Sun Microsystems, IBM, Microsoft, Verisign, Dell,
      Apple, HP, Cisco, Nokia, Adobe, Macromedia, Checkpoint, Symantec, Appligent
      and
      Quest. We have purchased or licensed all the equipment and software and we
      have
      not leased or borrowed to acquire any of them. These software and hardware
      systems will need periodic upgrades in the future as part of normal operation
      of
      business, which will be an added expense.





We
      also
      use certain software from leading opensource communities like Sun Microsystems,
      Apache Group, GNU, Suse (Novell) that are free and available in the public
      domain. The OneBiz SM Platform
      will use additional public domain software, if needed for successful
      implementation and deployment. In addition, the accounting software included
      in
      the OneBiz SM Platform
      is being supplied by another company. This accounting software will be a
      critical element in selling all our software on the OneBiz SM Platform. If this third party accounting software is not attractive to a wide
      range of small businesses, or has defects, our entire sales campaign will be
      substantially damaged. Using such software does not guarantee us support and
      upgrades of the software, and therefore could cause disruption in our service,
      if certain critical defects are discovered in the software at a future
      date.





The
      hardware and software we use may not continue to be available on commercially
      reasonable terms, or at all, or upgrades may not be available when we need
      them.
      We are not currently aware of any problems, but any loss of the right to use
      any
      of this hardware or software could result in delays in the provisioning of
      our
      services until equivalent technology is either developed by us, or, if
      available, is identified, obtained and integrated, which could harm our
      business. Any errors or defects in, or unavailability of, third-party hardware
      or software could result in errors or a failure of our service, which could
      harm
      our business.





**(16)
      Interruption Of Our Operations Could Significantly Harm Our
      Business.**





Significant
      portions of our operations depend on our ability to protect our computer
      equipment and the information stored in such equipment, our offices, and our
      hosting facilities against damage from fire, power loss, telecommunications
      failures, unauthorized intrusion, and other events. We back up software and
      related data files regularly and store the backup files at an off-site location.


43
 Index


However,
      there can be no assurance that our disaster preparedness will eliminate the
      risk
      of extended interruption of our operations. In connection with our subscription
      and hosting services, we have engaged third-party hosting facility providers
      to
      provide the hosting facilities and certain related infrastructure for such
      services. We also retain third-party telecommunications providers to provide
      Internet and direct telecommunications connections for our services. These
      providers may fail to perform their obligations adequately. Any damage or
      failure that interrupts our operations or destroys some or all of our data
      or
      the data of our customers, whether due to natural disaster or otherwise, could
      expose us to litigation, loss of customers, or other harm to our business.





**(17)
      Defects in Our Service Could Diminish Demand for Our Service and Subject Us
      to
      Substantial Liability, Damage Our Reputation, Or Otherwise Harm Our
      Business.**





Because
      our service is complex, it may have errors or defects that users identify after
      they begin using it, which could harm our reputation and our business.
      Internet-based services frequently contain undetected errors when first
      introduced or when new versions or enhancements are released. We have from
      time
      to time found defects in our service and new errors in our existing service
      may
      be detected in the future. Since our customers use our service for important
      aspects of their business, any errors, defects or other performance problems
      with our service could hurt our reputation and may damage our customers’
businesses. In addition to technical defects, our products could have errors
      related to the subject matter they address. For example, our accounting
      applications might cause users to make accounting mistakes due to our software
      not incorporating correct accounting practices or our HR software may have
      mistakes that cause users to have liability to their employees. Even if the
      initial releases of our applications do not contain errors, changes in
      accounting practices or rules related to employers could cause our applications
      to become outdated. If any of the foregoing occurs, customers could elect not
      to
      renew, or delay or withhold payment to us, we could lose future sales or
      customers may make warranty claims against us, which could result in an increase
      in our provision for doubtful accounts, an increase in collection cycles for
      accounts receivable or the expense and risk of litigation. In addition, the
      fear
      that any of the foregoing could occur may cause customers to choose to purchase
      the products of our larger competitors in the belief that larger companies
      are
      more reliable.





**(18)
      Security and Other Concerns may Discourage Use of Our Internet Based
      Software-as-Service (SaS) Model, Which Could Harm Our
      Business.**





Our
      service involves the storage and transmission of customers’ proprietary
      information, and security breaches could expose us to a risk of loss of this
      information, litigation and possible liability. If our security measures are
      breached as a result of third-party action, employee error, malfeasance or
      otherwise, and, as a result, someone obtains unauthorized access to one of
      our
      customers’ data, our reputation will be damaged, our business may suffer and we
      could incur significant liability. Because techniques used to obtain
      unauthorized access or to sabotage systems change frequently and generally
      are
      not recognized until launched against a target, we may be unable to anticipate
      these techniques or to implement adequate preventative measures. If an actual
      or
      perceived breach of our security occurs, the market perception of the
      effectiveness of our security measures could be harmed and we could lose sales
      and customers. If customers determine that our services offerings do not provide
      adequate security for the dissemination of information over the Internet or
      corporate extranets, or are otherwise inadequate for Internet or extranet use
      or
      if, for any other reason, customers fail to accept our products for use, our
      business will be harmed.





As
      part
      of our operations, we receive credit card, employee, purchasing, supplier,
      and
      other financial and accounting data, through the Internet or extranets. Although
      we have security systems in place, there can be no assurance that this
      information will not be subject to computer break-ins, theft, and other improper
      activity that could jeopardize the security of information for which we are
      responsible. Any such lapse in security could expose us to litigation, loss
      of
      customers, or other harm to our business. In addition, any person who is able
      to
      circumvent our security measures could misappropriate proprietary or
      confidential customer information or cause interruptions in our operations.
      We
      may be required to incur significant costs to protect against security
      breaches, to alleviate problems caused by breaches, or to encrypt
      additional key sensitive data to accommodate privacy laws or security measures.
      Any general concern regarding security in the marketplace could deter customers
      or prospects from using the Internet to conduct transactions that involve
      transmitting confidential information. Our failure to prevent security breaches,
      or well-publicized security breaches affecting the Internet in general, could
      significantly harm our business, operating results, and financial
      condition.





**(19)
      If We Experience Significant Fluctuations In Our Operating Results And Rate
      Of
      Growth And Fail To Balance Our Expenses With Our Revenue and Earnings
      Expectations, Our Results Will Be Harmed And Our Stock Price May Fall Rapidly
      And Without Advance Notice.** ******




Due
      to
      our limited operating history, our evolving business model and the
      unpredictability of our emerging industry, we may not be able to accurately
      forecast our rate of growth. We base our current and future expense levels
      and
      our investment plans on estimates of future revenue and future rate of growth.
      Our expenses and investments are, to a large extent, fixed and we expect that
      these expenses will increase in the future. We may not be able to adjust our
      spending quickly enough if our revenue falls short of our expectations.


44
 Index




As
      a
      result, we expect that our operating results may fluctuate significantly on
      a
      quarterly basis. Revenue growth may not be sustainable and may decrease in
      the
      future. We believe that period-to-period comparisons of our operating results
      may not be meaningful, and you should not rely upon them as an indication of
      future performance.





**(20)
      Because We Recognize Revenue From Our Partners Over The Term Of The Agreement,
      Downturns or Upturns In Sales May Not Be Immediately Reflected in Our Operating
      Results.** ******




We
      generally recognize revenue from partners ratably over the terms of their
      agreements. As a result, much of the revenue we report in each quarter is
      deferred revenue from partner agreements entered into during previous quarters.
      Consequently, a decline in new or renewed partners in any one quarter will
      not
      necessarily be fully reflected in the revenue in that quarter and will
      negatively affect our revenue in future quarters. In addition, we may be unable
      to adjust our cost structure to reflect these reduced revenues. Accordingly,
      the
      effect of significant downturns in transactions with our partners may not be
      fully reflected in our results of operations until future periods. Our reliance
      on revenue from our partners makes it difficult for us to rapidly increase
      our
      partner revenue through additional sales in any period, as revenue from new
      partners must be recognized over the applicable agreement term.





**RISKS
      ASSOCIATED WITH OUR MARKETS, CUSTOMERS AND PARTNERS**





**(21)
      If Our On-Demand Application Service is Not Widely Accepted, Our Operating
      Results Will Be Harmed.**





Historically,
      we have derived a small percentage of our revenue from subscriptions to our
      on-demand application service, but our business plan requires us to
      substantially increase this source of revenue in the future. As a result,
      widespread acceptance of our service is critical to our future success. Factors
      that may affect market acceptance of our service include:





·   potential
      reluctance by businesses to migrate to an on-demand application
      service;


·   the
      price
      and performance of our service;


·   the
      level
      of customization we can offer;


·   the
      availability, performance and price of competing products and services;
      and


·   potential
      reluctance by businesses to trust third parties to store and manage their
      internal data.





Many
      of
      these factors are beyond our control. The inability of our service to achieve
      widespread market acceptance would harm our business.





**(22)
      The Market for Our Technology Delivery Model and On-Demand Application Services
      Is Immature And Volatile, and if It Does Not Develop or Develops More Slowly
      Than We Expect, Our Business Will Be Harmed.**





The
      market for on-demand application services is new and unproven, and it is
      uncertain whether these services will achieve and sustain high levels of demand
      and market acceptance. Our success will depend to a substantial extent on the
      willingness of businesses to increase their use of on-demand application
      services. Many businesses have invested substantial personnel and financial
      resources to integrate traditional business software into their businesses,
      and
      therefore may be reluctant or unwilling to migrate to on-demand application
      services. Furthermore, some businesses may be reluctant or unwilling to use
      on-demand application services because they have concerns regarding the risks
      associated with security capabilities, among other things, of the technology
      delivery model associated with these services. If businesses do not perceive
      the
      benefits of on-demand application services, then the market for these services
      may not develop at all, or it may develop more slowly than we expect, either
      of
      which would significantly adversely affect our operating results. In addition,
      because this is an unproven market, we have limited insight into trends that
      may
      develop and affect our business. We may make errors in predicting and reacting
      to relevant business trends, which could harm our business.





**(23)
      We Do Not Have an Adequate History With Our Subscription Model To Predict the
      Rate of Customer Subscription Renewals and the Impact These Renewals Will Have
      on Our Revenue or Operating Results.**





Our
      small
      business customers do not sign long-term contracts. Our customers have no
      obligation to renew their subscriptions for our service after the expiration
      of
      their initial subscription period and in fact, customers have often elected
      not
      to do so. In addition, our customers may renew for a lower priced edition of
      our
      service or for fewer users. Many of our customers utilize our services without
      charge. We have limited historical data with respect to rates of customer
      subscription renewals for paying customers, so we cannot accurately predict
      customer renewal rates. Our customers’ renewal rates may decline or fluctuate as
      a result of a number of factors, including when we begin charging for our
      services, their dissatisfaction with our service and their ability to continue
      their operations and spending levels. If our customers do not renew their
      subscriptions for our service, our revenue may decline and our business will
      suffer.


45
 Index








**(24)
      We Depend on Small Businesses for Our Revenue. Small Businesses are Often
      Financially Unstable, Have High Rates of Attrition and can be Expensive
      Customers to Which to Market Products.**





Substantially
      all our revenue is from small business customers with fifty or fewer employees,
      whether directly or indirectly from our partners who do business with small
      businesses. Although this is a large market, it can be very expensive to
      penetrate this market. Each customer results in only a small amount of revenue.
      In addition, small businesses are often financially unstable, which can cause
      them to go out of business. Our small business customers typically have short
      initial subscription periods and, based on our experience to date, have had
      a
      high rate of attrition and non-renewal. If we cannot replace our small business
      customers that do not renew their subscriptions for our service with new paying
      customers quickly enough, our revenue could decline. This adversely affects
      our
      ability to develop long-term customer relationships. We must continually attract
      new customers to maintain the same level of revenue.





**(25)
      If We Fail to Develop Our Brand Cost-Effectively, Our Business May
      Suffer.**





We
      believe that developing and maintaining awareness of the Smart Online brand
      in a
      cost-effective manner is critical to achieving widespread acceptance of our
      existing and future services and is an important element in attracting new
      customers. Furthermore, we believe that the importance of brand recognition
      will
      increase as competition in our market develops. Successful promotion of our
      brand will depend largely on the effectiveness of our marketing efforts and
      on
      our ability to provide reliable and useful services at competitive prices.
      In
      the past, our efforts to build our brand have involved significant expense.
      Brand promotion activities may not yield increased revenue, and even if they
      do,
      any increased revenue may not offset the expenses we incurred in building our
      brand. If we fail to successfully promote and maintain our brand, or incur
      substantial expenses in an unsuccessful attempt to promote and maintain our
      brand, we may fail to attract enough new customers or retain our existing
      customers to the extent necessary to realize a sufficient return on our
      brand-building efforts, and our business could suffer.





**(26)
      We Depend on Corporate Partners to Market Our Products Through Their Web Sites
      and OEM or Integration Relationships Under Relatively Short Term Agreements.
      Termination of These Agreements Could Cause A Substantial Decline in Our Revenue
      and a Substantial Increase in Customer Acquisition Costs.**





Approximately
      91% of total revenue during the first half of 2005, approximately 93% of total
      revenue during year 2004, approximately 83% of total revenue during year 2003,
      and approximately 80% of total revenue during year 2002 was derived from
      syndication, integration and OEM agreements with large companies and related
      parties whereby our content, software applications and technology platform
      are
      integrated into the web sites of our syndication partners and the software
      and
      services of our integration partners is sold on our website, and our CD-ROM
      products are bundled with the products of others through our OEM relationships.
      Under these agreements we both derive revenue and we utilize the resources
      of
      our partners to reduce our customer acquisition costs. As of November 1, 2005,
      we have six syndication agreements, where we currently or will have our content
      and software on the website of large corporate partners. As of November 1,
      2005,
      we have eight integration partnership agreements where we integrate the
      content or services of our partners into our technology platform. As of November
      1, 2005, we have one OEM relationship through our distributor, PC
      Treasures. Not
      all
      these agreements generate revenue for us at this time. These agreements
      typically have initial terms of from one to three years. In the event these
      agreements were to terminate or not be renewed, or their terms substantially
      renegotiated, we expect that our revenues would decline and our customer
      acquisition costs would increase. Although our partners are important to our
      business on a collective basis, no single partner is material to our business.
      The syndication, integration, and OEM agreement revenue described above includes
      revenue from an integration agreement between Smart Online and Smart IL, a
      related party owned by a shareholder of Smart Online. Smart IL accounted for
      approximately 0% of our total revenues in the first half of 2005, approximately
      32.9% of total revenue during 2004 and approximately 27.2% of our total
      revenue during 2003.  Smart IL is not expected to contribute to our
      revenue in the future. Our dealings with Smart IL are described under
“Management Discussion and Analysis of Financial Condition and Results of
      Operations - Revenue From Related Parties.”





**(27)
      It is Important for Us to Continue to Develop and Maintain Strategic
      Relationships. We Have Failed to Sign Any New Significant Strategic Partner
      Relationships Since the Beginning of the Second Quarter of 2005. Failure to
      Do
      So Could Harm Our Business.**





We
      depend
      on syndication and integration partners, OEM relationships and referral
      relationships to offer products and services to a larger customer base than
      we
      can reach through direct sales, and other marketing efforts. Approximately
      81%
      of our total revenue during 2002 and approximately 83% of our total revenue
      during 2003 and approximately 93% of our total revenue during 2004 was derived
      through such relationships. We have not signed a new significant strategic
      partner relationship since the beginning of the second quarter of 2005. If
      we are unable to maintain our existing strategic relationships or enter into
      additional strategic relationships, we will have to devote substantially
      more resources to the distribution, sales, and marketing of our products and


46
 Index


services.
      Our success depends in part on the ultimate success of our syndication and
      integration partners, OEM relationships and referral partners and their ability
      to market our products and services successfully. Our partners are not obligated
      to provide potential customers to us. In addition, some of these third parties
      have entered, and may continue to enter, into strategic relationships with
      our
      competitors. Further, many of our strategic partners have multiple strategic
      relationships, and they may not regard us as significant for their businesses.
      Our strategic partners may terminate their respective relationships with us,
      pursue other partnerships or relationships, or attempt to develop or acquire
      products or services that compete with our products or services. Our strategic
      partners also may interfere with our ability to enter into other desirable
      strategic relationships. One of our syndication partnership agreements with
      Gruner + Jahr USA Publishing, pursuant to which we syndicate our platform and
      applications to the websites www.Inc.com and www.FastCompany.com ,
      contains a prohibition against our syndicating our platform and applications
      to
      two competitors of Gruner + Jahr. All of our integration partnership agreements
      limit our ability to integrate products or services onto our website that
      compete with the products or services being provided through our website by
      our
      integration partners.





**(28)
      Our Lengthy Sales Cycle with Syndication, Integration Partners and OEM
      Relationships Could Adversely Affect Our Financial
      Results.**





Our
      syndication and integration partners and OEM relationships typically commit
      significant resources to an evaluation of available solutions and require us
      to
      expend substantial time, effort, and money educating them about the value of
      our
      services and software. Our sales cycle, which is the time between initial
      contact with a potential partner and ultimately signing a contract, is often
      lengthy and unpredictable. As a result, we have limited ability to forecast
      the
      timing and size of new specific partnering and OEM relationships. In addition,
      revenue may not begin to flow from such contracts until long after they are
      signed due to delays in implementing the contracts or the failure of our
      partners to devote the resources required to promote our products to small
      businesses. Any delay in signing or implementing syndication, integration and
      OEM contracts or other strategic agreements could cause our operating results
      to
      vary significantly.





**(29)
      We Face Significant Competition, Which Could Adversely Affect Our
      Business.**





The
      market for our solutions is intensely competitive and rapidly changing. The
      direct competition we face depends on the market segment focus and delivery
      model capabilities of our competitors. We also at times have to overcome
      customer reluctance to move away from existing paper-based systems. We have
      two
      primary categories of competitors: companies that offer a broad range of
      software applications for small businesses and companies that offer one or
      two
      applications that compete with our broad range of applications. Our principal
      direct competition primarily comes from large companies, such as Microsoft,
      Oracle, Intuit, SAP and Yahoo!, who provide multiple software products used
      by
      many small businesses. In addition, we face competition from other competitors
      who sell single applications. Salesforce.com is an example of one of the many
      companies that fall within this second category of competitors. Many of our
      competitors have longer operating histories, greater financial, technical,
      marketing, and other resources, greater name recognition, and a larger total
      number of customers for their products and services than we do. Some of our
      competitors sell many products to our current and potential customers, as well
      as to systems integrators and other vendors and service providers. These
      competitors may also be able to respond more quickly to new or emerging
      technologies and changes in customer requirements, or to devote greater
      resources to the development, promotion, and sale of their products, than we
      may
      be able to do. In addition, we anticipate new competitors will enter the market
      in the future. Increased competition may result in price reductions, reduced
      gross margins, and change in market share and could have a material adverse
      effect on our business, financial condition, and results of operations. New
      product announcements by competitors may make it difficult to sell our products
      even before the competitor releases the product. For example, Microsoft has
      announced that it intends to introduce a new small business accounting
      application in 2006.





**(30)
      We Depend on Nonrecurring Revenue, Which May Cause Our Revenue to Fluctuate
      Substantially From One Quarter to Another or to Decline Permanently as Market
      Conditions Change.**





We
      depend
      on nonrecurring revenue. Nonrecurring revenue is primarily derived from
      integration fees and other up-front payments received upon signing syndication
      and integration agreements with corporate partners for which we charge a
      one-time fee. This revenue is recognized on a monthly basis over the initial
      term of the integration and syndication contracts and may fluctuate
      substantially from one quarter to another. All of our integration revenues
      were
      from nonrecurring sources during the years ended December 31, 2003 and December
      31, 2004. Approximately 68% of our syndication revenues for 2004, 48% of our
      syndication revenues for 2003, and 52% of our syndication revenues for 2002
      were
      from nonrecurring sources. In addition, such revenue may substantially decrease
      on a permanent basis due to market conditions over which we have little or
      no
      control, including competitors introducing new products to the market or
      reducing the price of competing products.





**(31)
      We Depend on Web Services Revenues; Our Future Growth is Substantially Dependent
      on Customer Demand for Our Subscription Services Delivery Models. Failure to
      Increase This Revenue Could Harm Our Business.**


47
 Index





Revenues
      from small businesses for our Web Services, which include subscriptions, revenue
      share, e-commerce fees, hosting fees, loan origination fees and marketing fees,
      represented approximately 6.3% of our total revenue for the first half of 2005,
      6.2% of our total revenue for 2004, and approximately 16.5% of total revenue
      for
      fiscal 2003. We anticipate that Web Services revenues will continue to represent
      a significant percentage of our total revenues and that our future financial
      performance and revenue growth will depend, in large part, upon the growth
      in
      customer demand for our outsourced services delivery models. As such, we have
      invested significantly in infrastructure, operations, and strategic
      relationships to support these models, which represent a significant departure
      from the delivery strategies that other software vendors and we have
      traditionally employed. To maintain positive margins for our small business
      services, our revenues will need to continue to grow more rapidly than the
      cost
      of such revenues. There can be no assurance that we will be able to maintain
      positive gross margins in our subscription services delivery models in future
      periods. If our subscription services business does not grow sufficiently,
      we
      could fail to meet expectations for our results of operations, which could
      harm
      our business.





Any
      delays in implementation may prevent us from recognizing subscription revenue
      for periods of time; even when we have already incurred costs relating to the
      implementation of our subscription services. Additionally, customers can cancel
      our subscription services contracts at any time and, as a result, we may
      recognize substantially less revenue than we expect. If large numbers of
      customers cancel or otherwise seeks to terminate subscription agreements quicker
      than we expect, our operating results could be substantially harmed. To become
      successful, we must cause subscribers who do not pay fees to begin paying fees
      and increase the length of time subscribers pay subscription fees.





**(32)
      There are Risks Associated with International Operations, Which We Expect Will
      Become a Bigger Part of Our Business in the Future.**





We
      currently do not generate substantial revenue from international operations,
      but
      we plan to conduct greater international operations in the future. Our
      international operations will be subject to risks associated with operating
      abroad. We expect international operations will become an important component
      of
      our business. These international operations are subject to a number of
      difficulties and special costs, including:





·   costs
      of
      customizing products for foreign countries;


·   laws
      and
      business practices favoring local competitors;


·   uncertain
      regulation of electronic commerce;


·   compliance
      with multiple, conflicting, and changing governmental laws and
      regulations;


·   longer
      sales cycles; greater difficulty in collecting accounts receivable;


·   import
      and export restrictions and tariffs;


·  potentially
      weaker protection for our intellectual property than in the United States,
      and
      practical difficulties in enforcing such rights abroad;


·   difficulties
      staffing and managing foreign operations;


·   multiple
      conflicting tax laws and regulations; and


·   political
      and economic instability.





Our
      international operations will also face foreign currency-related risks. To
      date,
      most of our revenues have been denominated in United States Dollars, but we
      believe that an increasing portion of our revenues will be denominated in
      foreign currencies. We currently do not engage in foreign exchange hedging
      activities, and therefore our international revenues and expenses are currently
      subject to the risks of foreign currency fluctuations.





We
      must
      also customize our services and products for international markets. This process
      is much more complex than merely translating languages. For example, our ability
      to expand into international markets will depend on our ability to develop
      and
      support services and products that incorporate the tax laws, accounting
      practices, and currencies of applicable countries. Since a large part of our
      value proposition to customers is that our products have been developed with
      the
      peculiar needs of small businesses in mind, any variation in business practice
      from one country to another may substantially decrease the value of our products
      in that country, unless we identify the important differences and customize
      our
      product to address the differences.





Our
      international operations also increase our exposure to international laws and
      regulations. If we cannot comply with foreign laws and regulations, which are
      often complex and subject to variation and unexpected changes, we could incur
      unexpected costs and potential litigation. For example, the governments of
      foreign countries might attempt to regulate our services and products or levy
      sales or other taxes relating to our activities. In addition, foreign countries
      may impose tariffs, duties, price controls or other restrictions on foreign
      currencies or trade barriers, any of which could make it more difficult for
      us
      to conduct our business in international markets.


48
 Index





We
      intend
      to expand our international sales and marketing activities and enter into
      relationships with additional international distribution partners. We are in
      the
      early stages of developing our indirect distribution channels in markets outside
      the United States. We may not be able to attract and retain distribution
      partners that will be able to market our products effectively.





**(33)
      Historically Substantial Amounts of Our Revenue Were Derived From Transactions
      with Related Parties, Which Means That Our Revenue May Not Reflect the True
      Commercial Viability of Our Business and That Our Revenue May Decline If We
      Cannot Replace this Revenue With Revenue From Unrelated Third
      Parties.**





During
      2004, approximately $330,000 of our total revenue, constituting approximately
      32.9% of total 2004 revenue, was derived from related party transactions. During
      2003, approximately $513,057 of our total revenue, constituting approximately
      40.7% of 2003 total revenue, was derived from transactions with parties in
      which
      our officers, directors and stockholders have a direct or indirect interest.
      For
      year 2002, related party transactions provided approximately $140,149 of our
      revenue, constituting approximately 10.1% of 2002 total revenue. None of our
      revenues during the first half of 2005 was derived from related
      parties.





Because
      our officers, directors and stockholders derive a benefit from promoting the
      success of our business, these transactions may have been entered into by these
      related parties to promote our business. Consequently, revenue derived from
      these transactions may not be as indicative of the true commercial viability
      of
      our business as revenue derived from transactions with unrelated
      parties.





Our
      officers, directors and stockholders have limited resources and will not be
      able
      to enter into the same dollar volumes of transactions in the future as in the
      past. Having high amounts of revenue from related party transactions, therefore,
      means our revenue will decrease, if we are not able to replace this revenue
      with
      revenue from transactions with unrelated parties. Specifically, one related
      party, Smart IL, which accounted for approximately 32.9% of our total revenue
      during 2004 and approximately 27.2% of our total revenue during 2003, is not
      expected to contribute to our revenue in the future. See “Management’s
      Discussion and Analysis of Financial Condition and Results of Operations -
      Revenue from Related Parties,” for a description of our dealings with Smart
      IL.





**RISKS
      ASSOCIATED WITH OUR OFFICERS, DIRECTORS, EMPLOYEES AND
      STOCKHOLDERS**





**(34)
      Any Failure to Adequately Expand Our Direct Sales Force Will Impede Our Growth,
      Which Could Harm Our Business.**





We
      expect
      to be substantially dependent on our direct sales force to obtain new customers.
      We believe that there is significant competition for direct sales personnel
      with
      the advanced sales skills and technical knowledge we need. Our ability to
      achieve significant growth in revenue in the future will depend, in large part,
      on our success in recruiting, training and retaining sufficient direct sales
      personnel. New hires require significant training and may, in some cases, take
      more than a year before they achieve full productivity. Our recent hires and
      planned hires may not become as productive as we would like, and we may be
      unable to hire sufficient numbers of qualified individuals in the future in
      the
      markets where we do business. If we are unable to hire and develop sufficient
      numbers of productive sales personnel, sales of our services will
      suffer.





**(35)
      Because Competition for Our Target Employees Is Intense, We May Not Be Able
      to
      Attract and Retain the Highly Skilled Employees We Need to Support Our Planned
      Growth, Which Could Harm Our Business.**





To
      execute our growth plan, we must attract and retain highly qualified personnel.
      Competition for these personnel is intense, especially for engineers with high
      levels of experience in designing and developing software and Internet-related
      services and senior sales executives. We may not be successful in attracting
      and
      retaining qualified personnel. We have from time to time in the past
      experienced, and we expect to continue to experience in the future, difficulty
      in hiring and retaining highly skilled employees with appropriate
      qualifications. Many of the companies with which we compete for experienced
      personnel have greater resources than we have. In addition, in making employment
      decisions, particularly in the Internet and high-technology industries, job
      candidates often consider the value of the stock options they are to receive
      in
      connection with their employment. Significant volatility in the price of our
      stock may, therefore, adversely affect our ability to attract or retain key
      employees. Furthermore, the new requirement to expense stock options may
      discourage us from granting the size or type of stock options awards that job
      candidates require to join our company. If we fail to attract new personnel
      or
      fail to retain and motivate our current personnel, our business and future
      growth prospects could be severely harmed.





**(36)
      Our Growth Could Strain Our Personnel and Infrastructure Resources, and if
      We
      Are Unable to Implement Appropriate Controls and Procedures To Manage Our
      Growth, We May Not Be Able to Successfully Implement Our Business
      Plan.**





We
      plan
      to have a period of rapid growth in our headcount and operations, which has
      placed, and will continue to place, a significant strain on our management,
      administrative, operational and financial infrastructure. We anticipate that
      further growth will be required to address increases in our customer base,
      as
      well as our expansion into new geographic areas. During the second quarter
      of
      2005, we added sales personnel in California and Georgia. During the third
      quarter of 2005, we added a sales person in New Jersey.  With the
      Computility acquisition, we added 17 new employees in October 2005. With the
      iMart acquisition, we added 22 employees.


49
 Index





Our
      success will depend in part upon the ability of our senior management to manage
      this growth effectively. To do so, we must continue to hire, train and manage
      new employees as needed. If our new hires perform poorly, or if we are
      unsuccessful in hiring, training, managing and integrating these new employees,
      or if we are not successful in retaining our existing employees, our business
      may be harmed. To manage the expected growth of our operations and personnel,
      we
      will need to continue to improve our operational, financial and management
      controls and our reporting systems and procedures. The additional headcount
      and
      capital investments we are adding will increase our cost base, which will make
      it more difficult for us to offset any future revenue shortfalls by offsetting
      expense reductions in the short term. If we fail to successfully manage our
      growth, we will be unable to execute our business plan.





**(37)
      Our Executive Management Team is Critical to the Execution of Our Business
      Plan
      and the Loss of Their Services Could Severely Impact Negatively on Our
      Business.**





Our
      success depends significantly on the continued services of our management
      personnel, including Michael Nouri, who is our chairman of the board, president
      and chief executive officer, and Henry Nouri, our Executive Vice President,
      Research and Development. Losing any one of our officers could seriously harm
      our business. Competition for executives is intense. If we had to replace any
      of
      our officers, we would not be able to replace the significant amount of
      knowledge that they have about our operations. All of our executive team work
      at
      the same location, which could make us vulnerable to loss of our entire
      management team in the event of a natural or other disaster.  We do not
      maintain key man insurance policies on anyone.





**(38)
      Officers, Directors and Principal Stockholders Control Us. This Might Lead
      Them
      to Make Decisions that do not Benefit the Stockholder Interests.**





At
      November 1, 2005, our officers and directors beneficially owned approximately
      5,222,364 (approximately 28%) of our outstanding stock, which includes
      approximately 689,501 shares which can be acquired upon exercise of options
      within sixty (60) days after November 1, 2005. These shares included
      approximately 3,752,027 shares beneficially owned by Michael Nouri and Henry
      Nouri, who are brothers. This number does not include 340,631 shares owned
      by
      Ronna Loprete, who is the wife of Michael Nouri and who recently resigned as
      an
      officer and director of Smart Online. In addition, 719,419 shares are
      subject to issuance upon exercise of options owned by the officers and
      directors, which options cannot be exercised within sixty days after November
      1,
      2005, and therefore are not counted as being beneficially owned at that date.
      As
      a result, these persons, acting together, will have the ability to control
      substantially all matters submitted to our stockholders for approval (including
      the election and removal of directors and any merger, consolidation or sale
      of
      all or substantially all of our assets) and to control our management and
      affairs. Accordingly, this concentration of ownership may have the effect of
      delaying, deferring or preventing a change in control of us, impeding a merger,
      consolidation, takeover or other business combination involving us or
      discouraging a potential acquirer from making a tender offer or otherwise
      attempting to obtain control of us, which in turn could materially and adversely
      affect the market price of our Common Stock.





**(39)
      Sales by Officers and Directors, Including Sales Under Rule 10b5-1
      Plans, Could Adversely Affect Our Stock Price.**





Sales
      of
      significant amounts of shares held by our directors and executive officers
      after
      their contractual lock-up provisions expire, or the prospect of these sales,
      could adversely affect our Common Stock price, both because significant sales
      could depress prices, and because sales by management could provide a negative
      signal to the market about our prospects.




The
        Board
        of Directors of Smart Online has approved a form of Rule 10b5-1 plan for
        the
        sale of Smart Online shares held by officers and key employees of Smart Online.
        The form of plan approved by the Board of Directors for use by officers and
        employees authorizes each person to sell 650 shares of Smart Online common
        stock
        each month.
 
 Insiders
        are often prohibited from trading shares of their company, because their
        duties
        often require them to possess material nonpublic information about their
        companies. Rule 10b5-1 was adopted by the SEC in October 2000 to facilitate
        insiders selling their company stock, if they establish a plan to regularly
        sell
        their shares and the plan satisfies the requirements of Rule 10b5-1, including
        that the insider must not possess material nonpublic information when the
        plan
        is initiated.
 
 Seven
        of
        our officers and employees, including our Chief Executive Officer, have
        indicated they intend to initiate Rule 10b5-1 plans utilizing the form of
        plan
        approved by our Board of Directors. We expect these plans will be initiated
        when
        our officers and key employees do not possess material nonpublic information
        about Smart Online. Currently, Smart Online has not filed with the SEC financial
        statements for Computility and iMart, which Smart Online acquired during
        October. We expect we will file with the SEC financial statements for
        Computility and iMart within the next month. We expect Rule 10b5-1 plans
        may be
        executed on or about the third trading day after such financial statements
        have
        been filed, if the officers and key employees do not possess other material
        nonpublic information about Smart Online at that time.
  Officers
        and key employees are not required to limit their sales of Smart Online shares
        to the number of shares stated in their plans. Consequently, you should not
        interpret the plans as setting any maximum limit on sales by such officers,
        directors or key employees, because officers, directors and key employees
        may
        sell Smart Online shares outside of their plans, whether or not they have
        executed any plans.


50
 Index






**(40)
      Shares of Common Stock Owned by Our Officers, Directors and Consultants Have
      Been Registered in a Registration on Form S-8 and May be Resold by Them, Which
      May Have a Negative Impact on Their Interest in Smart Online’s
      Future.**





In
      May
      2005, we registered 5,000,000 shares of our Common Stock for our officers,
      directors and consultants on Form S-8.  At November 1, 2005, 16,500 shares
      were outstanding and 1,886,750 shares are subject to outstanding stock
      options. This will allow our officers, directors and consultants to more easily
      sell all of their Smart Online stock after their contractual lock-up
      restrictions expire, which may have a negative impact on their interest in
      the
      future success of Smart Online. Shares owned by officers and directors are
      deemed to be “control” securities and, until Smart Online meets certain
      criteria, resales by officers and directors pursuant to a Form S-8 registration
      statement are subject to the volume limitations of Rule 144(e), which means
      that
      an officer or director would be entitled to sell within any three-month period
      a
      number of shares that does not exceed (i) 1% of the number of shares of Common
      Stock then outstanding, or (ii) the average weekly trading volume of the Common
      Stock during the four calendar weeks preceding the filing of a Form 144 with
      respect to such sale.


**REGULATORY
      RISKS**





**(41)
      Our Revenue Recognition Policy May Change And Affect Our Earnings, Which Could
      Adversely Affect Our Stock Price.**





We
      believe our current revenue recognition policies and practices are consistent
      with applicable accounting standards. However, revenue recognition rules for
      software and service companies are complex and require significant
      interpretations by management. Changes in circumstances, interpretations, or
      accounting guidance may require us to modify our revenue recognition policies.
      Such modifications could impact the timing of revenue recognition and our
      operating results. See “Management’s Discussion And Analysis Of Financial
      Condition And Results Of Operations” regarding our current revenue recognition
      policies.





**(42)
      Compliance With New Regulations Governing Public Company Corporate Governance
      and Reporting is Uncertain and Expensive. Our Difficulties in Complying with
      Public Company Reporting Obligations Are Greater, Because Our Chief Financial
      Officer Does Not Have Prior Experience with a Public
      Company.**





As
      a
      public company, we have incurred and will incur significant legal, accounting
      and other expenses that we did not incur as a private company. We will incur
      costs associated with our public company reporting requirements. We also
      anticipate that we will incur costs associated with recently adopted corporate
      governance requirements, including requirements under the Sarbanes-Oxley Act
      of
      2002, as well as new rules implemented by the Securities and Exchange Commission
      and the NASD. We expect these rules and regulations to increase our legal and
      financial compliance costs and to make some activities more time-consuming
      and
      costly. Any unanticipated difficulties in preparing for and implementing these
      reforms could result in material delays in complying with these new laws
      and regulations or significantly increase our costs. Our ability to fully comply
      with these new laws and regulations is also uncertain. Our failure to timely
      prepare for and implement the reforms required by these new laws and regulations
      could significantly harm our business, operating results, and financial
      condition. Our current chief financial officer does not have public company
      experience. Consequently, we will have greater difficulty complying with public
      company reporting requirements than most public companies. We also expect these
      new rules and regulations may make it more difficult and more expensive for
      us
      to obtain director and officer liability insurance and we may be required to
      accept reduced policy limits and coverage or incur substantially higher costs
      to
      obtain the same or similar coverage. As a result, it may be more difficult
      for
      us to attract and retain qualified individuals to serve on our board of
      directors or as executive officers. We are currently evaluating and monitoring
      developments with respect to these new rules. We estimate this will add
      approximately $500,000 to our expenses during our first year as a public
      company, but there can be no assurance that costs will not be
      higher.





**(43)
      We Believe Our Financial Results Will Be Adversely Affected By Changes in
      Accounting Principles Generally Accepted in the United
      States.**





Accounting
      principles generally accepted in the United States are subject to interpretation
      by the Financial Accounting Standards Board, or FASB, the American Institute
      of
      Certified Public Accountants, the Securities and Exchange Commission, or SEC,
      and various bodies formed to promulgate and interpret appropriate accounting
      principles. A change in these principles or interpretations could have a
      significant effect on our reported financial results, and could affect the
      reporting of transactions completed before the announcement of a
      change.





For
      example, in December 2004, the FASB announced its decision to require companies
      to expense employee stock options. We will adopt this new accounting
      pronouncement, Statement of Financial Accounting Standards No. 123 (revised
      2004), *Share-Based
      Payment* ,
      beginning on January 1, 2006, which is the start of fiscal 2006. We believe
      this
      change in accounting will materially and adversely affect our reported results
      of operations.





**(44)
      Privacy Concerns and Laws or Other Domestic or Foreign Regulations May Reduce
      the Effectiveness of Our Solution and Adversely Affect Our Business.**




Our
      customers can use our service to store contact and other personal or identifying
      information regarding their customers and contacts. Federal, state and foreign
      government bodies and agencies, however, have adopted or are considering
      adopting laws and regulations regarding the collection, use and disclosure
      of
      personal information obtained from consumers and individuals. The costs of
      compliance with, and other burdens imposed by, such laws and regulations that
      are applicable to the businesses of our customers may limit the use and adoption
      of our service and reduce overall demand for it. Furthermore, privacy concerns
      may cause our customers’ customers to resist providing the personal data
      necessary to allow our customers to use our service effectively. Even the
      perception of privacy concerns, whether or not valid, may inhibit market
      adoption of our service in certain industries. For example, regulations such
      as
      the Gramm-Leach-Bliley Act of 1999, which protects and restricts the use of
      consumer credit and financial information, and the Health Insurance Portability
      and Accountability Act of 1996, which regulates the use and disclosure of
      personal health information, impose significant requirements and obligations
      on
      businesses that may affect the use and adoption of our service.




51
 Index





The
      European Union has also adopted a data privacy directive that requires member
      states to impose restrictions on the collection and use of personal data that,
      in some respects, are far more stringent, and impose more significant burdens
      on
      subject businesses, than current privacy standards in the United States. All
      of
      these domestic and international legislative and regulatory initiatives may
      adversely affect our customers’ ability to collect and/or use demographic and
      personal information from their customers, which could reduce demand for our
      service.




In
      addition to government activity, privacy advocacy groups and the technology
      and
      other industries are considering various new, additional or different
      self-regulatory standards that may place additional burdens on us. If the
      gathering of personal information were to be curtailed in this manner, certain
      of our solutions would be less effective, which may reduce demand for our
      service and harm our business.





**(45)
      Our Business is Subject to Changing Regulations Regarding Corporate Governance
      and Public Disclosure That Has Increased Both Our Costs and the Risk of
      Noncompliance.**




We
      are
      subject to rules and regulations by various governing bodies, including the
      U.S.
      Securities and Exchange Commission, New York Stock Exchange and Public Company
      Accounting Oversight Board, which are charged with the protection of investors
      and the oversight of companies whose securities are publicly traded. Our efforts
      to comply with these new regulations, most notably the Sarbanes-Oxley Act,
      or
      SOX, have resulted in, and are likely to continue to result in, increased
      general and administrative expenses and a diversion of management time and
      attention to compliance activities.




By
      the
      end of fiscal 2007, we are required to comply with the SOX requirements
      involving the assessment of our internal controls over financial reporting
      and
      our external auditors’ audit of that assessment. Although we believe our
      on-going review and testing of our internal controls will enable us to be
      compliant with the SOX requirements, we may identify deficiencies that we may
      not be able to remediate by the end of fiscal 2007. If we cannot assess our
      internal controls over financial reporting as effective, or our external
      auditors are unable to provide an unqualified attestation report on such
      assessment, our stock price could decline.




Moreover,
      because these laws, regulations and standards are subject to varying
      interpretations, their application in practice may evolve over time as new
      guidance becomes available. This evolution may result in continuing uncertainty
      regarding compliance matters and additional costs necessitated by ongoing
      revisions to our disclosure and governance practices. If we fail to address
      and
      comply with these regulations and any subsequent changes, our business may
      be
      harmed.





**(46)
      Evolving Regulation of the Internet May Harm Our Business.**





As
      Internet commerce continues to evolve, increasing regulation by federal, state
      or foreign agencies becomes more likely. For example, we believe increased
      regulation is likely in the area of data privacy, and laws and regulations
      applying to the solicitation, collection, processing or use of personal or
      consumer information could affect our customers’ ability to use and share data,
      potentially reducing demand for our services and restricting our ability to
      store, process and share data with our customers. In addition, taxation of
      services provided over the Internet or other charges imposed by government
      agencies or by private organizations for accessing the Internet may also be
      imposed. Any regulation imposing greater fees for Internet use or restricting
      information exchange over the Internet could result in a decline in the use
      of
      the Internet and the viability of Internet-based services, which could harm
      our
      business.





**(47)
      Our Ability to Protect Our Intellectual Property is Limited and Our Products
      may
      be Subject to Infringement Claims by Third Parties.**





Our
      success depends, in part, upon our proprietary technology, processes, trade
      secrets, and other proprietary information, and our ability to protect this
      information from unauthorized disclosure and use. We rely on a combination
      of
      copyright, trade secret, and trademark laws, confidentiality procedures,
      contractual provisions, and other similar measures to protect our proprietary
      information.





We
      do not
      own any issued patents or have any patent applications pending. Despite our
      efforts to protect our proprietary rights, unauthorized parties may attempt
      to
      copy aspects of our products or to obtain and use information that we regard
      as
      proprietary, and third parties may attempt to develop similar technology
      independently. Policing unauthorized use of our products is difficult,
      particularly because the global nature of the Internet makes it difficult to
      control the ultimate destination or security of software or other data
      transmitted. While we are unable to determine the extent to which piracy of
      our
      software products exists, software piracy can be expected to be a persistent
      problem.


52
 Index





In
      addition, the laws of some foreign countries do not protect our proprietary
      rights to as great an extent as do the laws of the United States, and we expect
      that it will become more difficult to monitor use of our products as we increase
      our international presence. Over the past several years, we have made numerous
      changes in our product names. Although we own registered trademarks in the
      United States and have filed trademark applications in the United States and
      in
      certain other countries, we do not have assurance that our strategy with respect
      to our trademark portfolio will be adequate to secure or protect all necessary
      intellectual property. There can be no assurance that our means of protecting
      these proprietary rights will be adequate, or that our competitors will not
      independently develop similar technology.





The
      software and Internet industries are characterized by the existence of a large
      number of patents, trademarks and copyrights and by frequent litigation based
      on
      allegations of infringement or other violations of intellectual property rights.
      As the number of entrants into our market increases, the possibility of an
      intellectual property claim against us grows. Our technologies may not be able
      to withstand any third-party claims or rights against their use. Any
      intellectual property claims, with or without merit, could be time-consuming
      and
      expensive to litigate or settle, and could divert management attention from
      executing our business plan. In addition, our agreements often require us to
      indemnify our syndication partners for third-party intellectual property
      infringement claims, which would increase the cost to us of an adverse ruling
      in
      such a claim. An adverse determination could also prevent us from offering
      our
      service to others. No third party has asserted any intellectual property claims
      against us.





**(48)
      Anti-Takeover Effects of Charter Documents and Delaware Law Could Discourage
      or
      Prevent a Change in Control, Even If a Change of Control Would Be Beneficial
      to
      Shareholders and Investors.**





Provisions
      in our certificate of incorporation and bylaws, as amended and restated, as
      well
      as provisions of Delaware law may have the effect of delaying or preventing
      a
      change of control or changes in our management even if a change of control
      would
      be beneficial to our shareholders and investors. These provisions include the
      following:





·
            Our
                board of directors is divided into three classes whenever the number
                of
                directors is six or more, in which case, approximately one-third
                of our
                board of directors will be elected each year. This delays the ability
                of
                shareholders, including any acquiror, to change our board of
                directors.





·
            Our
                board of directors has the right to elect directors to fill a vacancy
                created by the expansion of the board of directors or the resignation,
                death or removal of a director, which prevents shareholders from
                being
                able to fill vacancies on our board of
                directors.





·
            Cumulative
                voting in the election of directors is not authorized by our certificate
                of incorporation. This limits the ability of minority shareholders
                to
                elect director candidates.





·
            Shareholders
                must provide advance notice to nominate individuals for election
                to the
                board of directors or to propose matters that can be acted upon at
                a
                shareholders’ meeting. This requirement may discourage or deter a
                potential acquiror from conducting a solicitation of proxies to elect
                the
                acquiror’s own slate of directors or otherwise attempting to obtain
                control of our company.





·
            Our
                board of directors may issue, without shareholder approval, shares
                of
                undesignated preferred stock. The ability to authorize undesignated
                preferred stock makes it possible for our board of directors to issue
                preferred stock with voting or other rights or preferences that could
                impede the success of any attempt to acquire
                us.





As
      a
      Delaware corporation, we are also subject to certain Delaware anti-takeover
      provisions. Under Delaware law, a corporation may not engage in a business
      combination with any holder of 15% or more of its capital stock, unless the
      holder has held the stock for three years or, among other things, the board
      of
      directors has approved the transaction. Our board of directors could rely on
      Delaware law to prevent or delay an acquisition of us even if a change of
      control would be beneficial to stockholders and investors. For a description
      of
      our capital stock, see “Description of Capital Stock.”


53
 Index





**RISKS
      ASSOCIATED WITH THE MARKET FOR OUR SECURITIES**





**(49)
      Our Common Stock Began Being Quoted for Trading on the Over-the-Counter
      Electronic Bulletin Board in April 2005, but There Is No Assurance Volume
      Trading Will Develop. Therefore You may be Unable to Sell Your
      Shares.**





Our
      Common Stock began trading on the Over-the-Counter Electronic Bulletin Board
      (“OTCBB” or “Bulletin Board”) during April 2005. Other public markets, such as
      NASDAQ’s Small Capital Market, have qualitative and quantitative listing
      criteria that we believe we currently meet, while other markets, such as
      NASDAQ’s National Market, have criteria we do not currently meet. These criteria
      include operating results, net assets, corporate governance, minimum trading
      price and minimums for public float, which is the amount of stock not held
      by
      affiliates of the issuer.





To
      remain
      eligible to have our securities quoted on OTCBB, we must file reports with
      the
      Securities and Exchange Commission pursuant to Section 13 or Section 15(d)
      of
      the Securities Act of 1933 and we must remain current in our periodical
      reporting obligations. A broker/dealer must also file a Form 211 with the
      National Association of Securities Dealers (“NASD”) to allow our Common Stock to
      be quoted on the OTCBB. For more information on the OTCBB see its web site
      at www.otcbb.com .





There
      can
      be no assurance our market maker will continue to quote our stock. If for any
      reason, our securities are not eligible for continued quotation on the Bulletin
      Board or a public trading market does not develop, purchasers of the shares
      may
      have difficulty selling their securities should they desire to do so. If we
      are
      unable to satisfy the requirements for quotation on the Bulletin Board, any
      trading in our Common Stock would be conducted in the over-the-counter market
      in
      what are commonly referred to as the “pink sheets.” The “pink sheets” are
      operated by a private company and are not affiliated with the NASD. However,
      a
      broker-dealer must file a Form 211 and undergo NASD review before it can quote
      securities on the “pink sheets.” Companies quoted on the “pink sheets” need not
      file periodic reports with the Securities and Exchange Commission. Trading
      volume for securities traded only on the “pink sheets” is generally lower than
      for securities traded on the OTCBB. If our securities were quoted for trading
      only on the “pink sheets,” an investor may find it more difficult to dispose of,
      or to obtain accurate quotations as to the price of, the securities offered
      hereby.





The
      above-described rules may materially adversely affect the liquidity of the
      market for our securities. There can be no assurance that an active trading
      market will ever develop or, if it develops, will be maintained. Failure to
      develop or maintain an active trading market could negatively affect the price
      of our securities, and you will be unable to sell your shares. If so, your
      investment will be a complete loss.





**(50)
      If Securities Analysts Do Not Publish Research or Reports About Our Business
      or
      If They Downgrade Our Stock, the Price of Our Stock Could
      Decline.**





The
      trading market for our Common Stock will rely in part on the research and
      reports that industry or financial analysts publish about us or our business.
      If
      we do not succeed in attracting analysts to report about our company, most
      investors will not know about our company even if we are successful in
      implementing our business plan. We do not control these analysts. There are
      many
      large, well established publicly traded companies active in our industry and
      market, which may mean it will be less likely that we receive widespread analyst
      coverage. Furthermore, if one or more of the analysts who do cover us downgrade
      our stock, our stock price would likely decline rapidly. If one or more of
      these
      analysts cease coverage of our company, we could lose visibility in the market,
      which in turn could cause our stock price to decline. Lower trading volume
      may
      also mean that you could not resell your shares.





**(51)
      Our Quarterly Revenues and Operating Results may Fluctuate in Future Periods
      and
      We may Fail to Meet Expectations of Investors and Public Market Analysts, Which
      Could Cause the Price of Our Common Stock to Decline.**





Our
      quarterly revenues and operating results may fluctuate significantly from
      quarter to quarter. If quarterly revenues or operating results fall below the
      expectations of investors or public market analysts, the price of our Common
      Stock could decline substantially. Factors that might cause quarterly
      fluctuations in our operating results include:





·
            the
                evolving demand for our services and
                software;


·
            spending
                decisions by our customers and prospective
                customers;


·
            our
                ability to manage expenses;


·
            the
                timing of new product releases;


·
            changes
                in our pricing policies or those of our
                competitors;


·
            the
                timing of execution of large
                contracts;


·
            changes
                in the mix of our services and software
                offerings;


·
            the
                mix of sales channels through which our services and software are
                sold;


·
            costs
                of developing new products and
                enhancements;


·
            global
                economic and political conditions;


·
            our
                ability to retain and increase sales to existing customers, attract
                new
                customers and satisfy our customers’
                requirements;


·
            the
                renewal rates for our service;


·
            the
                rate of expansion and effectiveness of our sales force;


·
            the
                length of the sales cycle for our
                service;


·
            new
                product and service introductions by our
                competitors;


·
            technical
                difficulties or interruptions in our
                service;


54
 Index





·
            regulatory
                compliance costs; payment defaults by customers;


·
            integration
                of acquisitions, and


·
            extraordinary
                expenses such as litigation or other dispute-related settlement
                payments.





In
      addition, due to a slowdown in the general economy and general uncertainty
      of
      the current geopolitical environment, an existing or potential
      customer may reassess or reduce their planned technology and Internet-related
      investments and defer purchasing decisions. Further delays or reductions in
      business spending for technology could have a material adverse effect on our
      revenues and operating results.





**(52)
      Our Stock Price is Likely to be Highly Volatile and May
      Decline.**





The
      trading prices of the securities of technology companies have been highly
      volatile. Accordingly, the trading price of our Common Stock has been and is
      likely to continue to be subject to wide fluctuations. Further, our Common
      Stock
      has a limited trading history. Factors affecting the trading price of our Common
      Stock include:





·
            variations
                in our actual and anticipated operating
                results;


·
            changes
                in our earnings estimates by
                analysts;


·
            the
                volatility inherent in stock prices within the emerging sector within
                which we conduct business;


·
            announcements
                of technological innovations, new services or service enhancements,
                strategic alliances or significant agreements by us or by our
                competitors;


·
            recruitment
                or departure of key personnel;


·
            changes
                in the estimates of our operating results or changes in recommendations
                by
                any securities analysts that elect to follow our Common
                Stock;


·
            market
                conditions in our industry, the industries of our customers and the
                economy as a whole;


·
            and
                the volume of trading in our Common Stock, including sales of substantial
                amounts of Common Stock issued upon the exercise of outstanding options
                and warrants.





In
      addition, the Over-the-Counter Bulletin Board administered by the NASD, on
      which
      our stock is quoted has experienced extreme price and volume fluctuations that
      have affected the trading prices of many technology and computer software
      companies, particularly Internet-related companies. Such fluctuations have
      often
      been unrelated or disproportionate to the operating performance of these
      companies. These broad trading fluctuations could adversely affect the trading
      price of our Common Stock.





Further,
      securities class action litigation has often been brought against companies
      that
      experience periods of volatility in the market prices of their securities.
      Securities class action litigation could result in substantial costs and a
      diversion of our management’s attention and resources. If such a suit is brought
      against us, we may determine, like many defendants in such lawsuits, that it
      is
      in our best interests to settle such a lawsuit even if we believe that the
      plaintiffs’ claims have no merit, to avoid the cost and distraction of continued
      litigation. Any liability we incur in connection with this potential lawsuit
      could materially harm our business and financial position and, even if we defend
      ourselves successfully, there is a risk that management’s distraction in dealing
      with this type of lawsuit could harm our results.





**(53)
      Shares Eligible for Public Sale Could Adversely Affect Our Stock Price.
      Holders of Shares of Our Common Stock Signed Agreements That Prohibit Resales
      of
      Approximately 9,954,624 shares of our Common Stock. The Lock-up Period Expired
      on September 30, 2005. If Substantial Numbers of Shares Are Resold On or After
      October 1, 2005, the Market Price of Our Common Stock Is likely to Decrease
      Substantially.**





At
      November 1, 2005, 15,605,270 shares of our common stock were issued and
      outstanding and 2,890,300 shares may be issued pursuant to the exercise of
      warrants and options.





4,145,950
      shares are being registered on a registration statement on Form S-1 that we
      anticipate filing prior to November 30, 2005; of these 1,394,758 shares and
      36,550 warrants to purchase shares were previously registered for resale on
      registration statement No. 333-119385 and are being reregistered for resale
      on
      the registration statement on Form S-1 that we anticipate filing prior to
      November 30, 2005. These 1,394,758 shares and 36,550 warrants to purchase shares
      represent a portion of the 1,942,833 shares and warrants to purchase shares
      registered for resale on registration statement No. 333-119385. Because of
      fundamental changes to Smart Online's business, shares cannot be resold under
      that registration statement.  Such shares may be sold pursuant to Rule 144.
      During May 2005, we registered on Form S-8 5,000,000 shares of our Common Stock
      for our officers, directors and consultants, of which at November 1, 2005,
      16,500 shares were outstanding and 2,826,750 shares are subject to outstanding
      stock options. The remaining outstanding shares are restricted and may be sold
      in the public market only if they qualify for an exemption from registration
      described below under Rules 144, 144(k) or 701 promulgated under the Securities
      Act.


55
 Index








**Rule
      144**





In
      general, under Rule 144 as currently in effect, but subject to the Lock-Up
      Agreements described below, if applicable, a person (or persons whose shares
      are
      aggregated) who has purchased our common stock from us or any “affiliate” of
      ours at least one year before the date of resale would be entitled to sell
      within any three-month period a number of shares that does not exceed the
      greater of: (i) 1% of the number of shares of our common stock then outstanding;
      or (ii) the average weekly trading volume of the volume of our common stock
      during the four calendar weeks preceding the filing of a Form 144 with respect
      to such sale. Sales under Rule 144 are also subject to manner of sale provisions
      and notice requirements, and to the availability of current public information
      about us.





In
      addition, a person who is not deemed to have been our “affiliate” at any time
      during the 90 days preceding a sale and who has beneficially owned for at least
      two years the shares proposed to be sold is entitled to sell such shares under
      Rule 144(k) without regard to the volume limitations and other requirements
      described above. Therefore, unless otherwise restricted, Rule 144(k) shares
      may
      be sold at any time. See the table below entitled “Rule 144 and Lock-Up Shares,”
setting forth the number of shares not sellable under Rule 144, the number
      sellable under Rule 144 with volume restrictions, and the number sellable under
      Rule 144(k) with no volume restrictions.





**Rule
      701**





Our
      employees, directors, officers and consultants who acquired Common Stock prior
      to February 15, 2005, (the date we became subject to the reporting requirements
      of the Exchange Act) under written compensatory benefit plans or written
      contracts relating to the compensation of those persons may rely on Rule 701
      with respect to the resale of that stock. In general, Rule 701 permits resales
      of shares issued under compensatory benefit plans and contracts in reliance
      upon
      Rule 144, but without compliance with certain restrictions, including the
      holding period requirements described in Rule 144. Accordingly, subject to
      the
      lock-up agreements described below, if applicable, under Rule 701 persons who
      received compensation shares and who are not our “affiliates” may resell those
      shares subject only to the manner of sale provisions of Rule 144, and persons
      who received compensation shares and who are our “affiliates” may resell those
      shares without compliance with Rule 144’s minimum holding period
      requirements.





**Equity
      Compensation Plans**





On
      May 3,
      2005, we filed a registration statement on Form S-8 under the Securities Act
      with respect to the 5,000,000 shares of the Common Stock reserved for issuance
      under our 2004 Equity Compensation Plan, which is now effective.  We also
      anticipate, as described below, filing additional registration statements on
      Form S-8 under the Securities Act with respect to certain shares of the Common
      Stock.





Shares
      registered on Form S-8, other than shares held by officers and directors, may
      be
      sold in the public markets. Shares registered on Form S-8 and held by our
      officers and directors may only be resold in compliance with the volume
      limitations of Rule 144(e), which means that an officer or director would be
      entitled to sell within any three-month period a number of shares that does
      not
      exceed the greater of: (i) 1% of the number of shares of Common Stock then
      outstanding; or (ii) the average weekly trading volume of the Common Stock
      during the four calendar weeks preceding the filing of a Form 144 with respect
      to such sale. Shares registered on Form S-8 held by persons other than officers
      and directors are not subject to any value limitations.





**Lock-Up
      Agreements**





Most
      of
      our security holders have signed lock-up agreements (the “Lock-up Agreements”)
      restricting the sale of our securities and/or agreements that limit the number
      of shares sellable during specific time periods (“Dribble Out Agreements”). The
      Dribble Out Agreements apply to all the shares sold by us in private placements
      and Regulation S offerings during 2004 and 2005, which shares have been
      registered for resale or which we are under an obligation to register for
      resale.





The
      number of outstanding shares subject to each Lock-Up Agreements and Dribble
      Out
      Agreements between Smart Online and its security holders is set forth below
      in
      the footnotes to the table entitled “Rule 144 and Lock-Up Shares.”





The
      lock-up period expired on September 30, 2005. Thereafter, shareholders who
      were
      prohibited from reselling shares may for one year sell up to 8.5% of the
      formerly locked up shares in any rolling 30-day period. Our stock is very thinly
      traded.


56
 Index





**Market
      Price Decline and Low Trading Volume**





The
      average trading volume for our Common Stock during September 2005 was
      approximately 20,000 shares per day. The number of shares that could be sold
      during this period was restrained by the lock-up agreements, while there was
      no
      similar contractual restraint on the number of buyers of our Common Stock.
      This
      means that market supply may increase more than market demand for our shares
      when the lock-up period expires. Many companies experience a decrease in the
      market price of their shares when a lock-up period terminates. At the beginning
      of October trading volume substantially increased for several days to over
      70,000 shares per day and our stock price declined substantially; at the
      beginning of November our trading volume was approximately 16,000 per day and
      our share price $8.10. At the beginning of each month people who sold during
      the
      preceding month are able to sell additional shares. If the volume of selling
      increases substantially at the beginning of each month, or at any other time
      in
      the future, the market price of our Common Stock is likely to decrease
      substantially.





We
      cannot
      predict if future sales of our common stock, or the availability of our common
      stock held for sale, will materially and adversely affect the market price
      for
      our common stock or our ability to raise capital by offering equity securities.
      Our stock price may decline, if the resale of shares under Rule 144, in addition
      to the resale of registered shares, at certain time in the future, exceeds
      the
      market demand for our stock.





Unless
      a
      trading market for our shares develops, you will not be able to resell your
      stock, and, market makers may influence the stock price. Market conditions
      and
      market makers may cause your investment in our common stock to significantly
      diminish and may become very illiquid.





We
      can
      offer no assurance that the volume of trading of our shares in the public
      markets will be sufficient to allow all sellers to sell at the times or prices
      sellers desire. Future sales of substantial amounts of our shares in the public
      market could adversely affect market prices prevailing from time to time and
      could impair our ability to raise capital through the sale of our equity
      securities.





**Summary
      Table**





The
      following table summarizes 15,605,270 shares outstanding as of November 1,
      2005
      by both (i) their resale status under Rule 144 and registration statements
      and
      (ii) restrictions or limits on resale under contracts between shareholders
      and
      Smart Online. The table also assumes the filing of the Form S-1 registering
      for
      sale 4,145,950 shares which we plan to file prior to November 30,
      2005.





**Rule
      144 and Lock-Up Shares** **(1)**





**COLUMN
                A**
            **COLUMN
                B**
            **COLUMN
                C**
            **COLUMN
                D**
            **COLUMN
                E**Lock-up
                Shares(8)
            33%
                Per Month
              Dribble-Out
                Shares(9)
            25%
                Per Month
              Dribble-Out
                Shares(10)
            Shares
                With No
              Contractual
              Restrictions
              on
                Resale(11)
            Totals
                Each RowShares
                Not Sellable
              under
                Rule 144(2)
            1,400
            None
            None
            758,779
            760,179Shares
                Sellable under
              Rule
                144with
              Rule
                144 Volume Restrictions(3)(4)
            6,546,954
            348,914
            None
            369,844
            7,265,712Shares
                Sellable under
              Rule
                144(k)without
              Rule
                144 Volume
              Restrictions(5)
            3,101,898
            None
            None
            174,137
            3,276,035Shares
                Registered for
              Resale(6)
            None
            1,183,501
            2,691,642
            39,500
            3,914,643Shares
                Available on
              Public
                Market(7)
            None
            None
            None
            388,701
            388,701Totals
                Each Column
            9,650,252
            1,532,415
            1,441,642
            2,980,961
            15,605,270





(1)
      Table
      includes only shares issued and outstanding as of November 1, 2005. Table does
      not include options or warrants.


57
 Index





(2)
      Represents shares purchased from Smart Online, or from an “affiliate” of Smart
      Online, as that term is defined in Rule 144, less than one year prior to
      November 1, 2005, and includes shares that have been registered on registration
      statement No. 333-119385 declared effective by the SEC on February 15, 2005.
      Effective as of the closing of the acquisitions of Computility and iMart
      described elsewhere in this prospectus, Smart Online has advised the holders
      of
      shares registered for resale on registration statement No. 333-119385 to no
      longer make sales under such registration statement. Does not include shares
      held for less than one year, but registered for resale on the registration
      statement on Form S-1 which we intend to file prior to November 30, 2005, as
      described in Footnote (6). Includes no shares held by “affiliates” of Smart
      Online, as that term is defined in Rule 144.





(3)
      Represents shares purchased from Smart Online, or from an “affiliate” of Smart
      Online, as that term is defined in Rule 144, more than one year but less than
      two years prior to November 1, 2005 and shares acquired pursuant to Rule 701.
      Also includes 5,773,756 shares held for a year or more by “affiliates” of Smart
      Online, as that term is defined in Rule 144.





(4)
      Does
      not include 1,066,002 shares held for more than one year, but less than two
      years, and registered for resale as described in Footnote (6).





(5)
      Represents shares purchased from Smart Online, or purchased from an “affiliate”
of Smart Online, as that term is defined in Rule 144, more than two years prior
      to November 1, 2005, other than such shares held by “affiliates” of Smart
      Online, as that term is defined in Rule 144 and shares held by affiliates
      acquired pursuant to Rule 701.





(6)
      Represents 4,145,950 outstanding shares covered by the registration statement
      on
      Form S-1 which we intend to file prior to November 30, 2005, none of which
      are
      owned by affiliates of Smart Online as that term is defined in Rule 144. During
      May 2005 a registration statement on Form S-8 covering shares of Smart
      Online’s 2004 Equity Compensation Plan was also filed and became effective,
      but these shares registered on Form S-8 are not included on this table until
      the
      options have been exercised; 16,500 shares are thus included in the table.
      Smart
      Online may file additional registration statements on Form S-8 to cover its
      other option plans.





(7)
      Represents shares which Smart Online is aware have been sold on the public
      market prior to November 1, 2005 either pursuant to registration statement
      No.
      333-119385 declared effective by the SEC on February 15, 2005, or pursuant
      to
      Rule 144. Effective as of the closing of the acquisitions of Computility and
      iMart described elsewhere in this prospectus, Smart Online has advised the
      holders of shares registered for resale on registration statement No. 333-119385
      to no longer make sales under such registration statement. Additional shares
      may
      have been sold on the public market, either pursuant to registration statement
      No. 333-119385 or Rule 144.





(8)
      Represents shares held by stockholders with whom Smart Online has entered into
      Lock-Up Agreements which provide, in general, for a lock-up that expires on
      September 30, 2006. Under these agreements, no resales of shares covered by
      the
      Lock-up Agreements were prohibited until October 1, 2005, and since October
      1,
      2005 each such stockholder is able sell or transfer up to 8.5% of the shares
      of
      Common Stock of that stockholder that are subject to the Lock-Up Agreement
      during each calendar month until September 30, 2006.





(9)
      Represents shares held by investors who purchased shares during 2004 with whom
      Smart Online has entered into Dribble Out Agreements which provide, in general,
      for a volume limitation that expires 18 months after effective date of the
      first
      registration statement that registers the shares for resale, which date was
      February 15, 2005. Consequently, the 18-month volume limitation continues until
      August 15, 2006. Under these agreements, each such stockholder may sell or
      transfer up to 33% of such holder’s shares of Common Stock covered by the
      Dribble Out Agreements during any rolling 30-day period prior to August 15,
      2006.





(10)
      Represents shares held by investors who purchased shares during 2005 with whom
      Smart Online has entered into Dribble Out Agreements which provide, in general,
      for a volume limitation that expires six months after the effective date of
      the
      first registration statement that registers such shares for resale. Under these
      agreements, commencing with the effective date of such registration statement,
      each such stockholder may sell or transfer up to 25% of such holder’s shares of
      Common Stock covered by the Dribble Out Agreements during any rolling 30-day
      period prior to the termination of the agreement. A registration statement
      to
      register these shares has not become effective as of November 1,
      2005.





(11)
      Represents shares held by stockholders with whom Smart Online has not entered
      into any Lock-Up Agreements or Dribble Out Agreements.


58
 Index







**Option
      and Warrant Table** **(1)**







The
      following table summarizes the number of shares issuable pursuant to currently
      exercisable options and warrants outstanding at November 1, 2005 by both (i)
      their resale status under Rules 701 and 144 and registration statements and
      (ii)
      restrictions or limits on resale under contracts between Smart Online and option
      holders and warrant holders.





**COLUMN
                A**
            **COLUMN
                B**
            **COLUMN
                C**
            **COLUMN
                D**
            **COLUMN
                E**Lock-up
                Shares(8)
            33%
                Per Month
              Dribble-Out
                Shares(9)
            25%
                Per Month
              Dribble-Out
                Shares(10)
            Shares
                With No Contractual Restrictions on Resale(11)
            Totals
                Each RowWarrant
                Shares
              Sellable
                under Rule 144with
              Volume
                Resale
              Limitations(2)
            None
            36,550
            None
            277,000
            313,550Option
                Shares Owned
              by
                Affiliates Sellable
              under
                Rule 701with
              Rule
                144 Volume
              Resale
                Limitations(3)
            650,000
            None
            None
            None
            650,000Option
                Shares Owned
              by
                Non-Affiliates
              Sellable
                under Rule
              701
                or Rule 144
              withoutRule 144
              Volume
                Resale
              Limitations(4)
            20,000
            None
            None
            20,000
            40,000Shares
                Owned by Non-
              Affiliates Registered
                on
              Form
                S-8 in May 2005(5)
            281,000
            None
            None
            771,750
            1,052,750Option
                Shares Owned
              by
                Affiliates
              Registered
                in May
              2005withRule
                144
              Volume
              Limitations(6)
            770,000
            None
            None
            64,000
            834,000Totals
                Each Column
            1,721,000
            36,550
            None
            1,132,750
            2,890,300





(1)
      Table
      includes only shares currently issuable upon exercise of warrants and options
      issued and outstanding as of November 1, 2005. Additional outstanding options,
      which are not currently exercisable, are not included in this
      Table.





(2)
      Represents options issued after February 15, 2005 and warrants where the shares
      issuable upon exercise of the options and warrants have not been registered
      for
      resale and which were not included in the Registration Statement on Form
      S-8 filed on May 3, 2005, but which may be included in a later
      registration statement on Form S-8.





(3)
      Represents options issued before February 15, 2005 to affiliates of Smart
      Online, as that term is defined in Rule 144, pursuant to Rule 701, which options
      are not included in the Registration Statement on Form S-8 filed and effective
      on May 3, 2005, but which may be included in a later registration statement
      on
      Form S-8.





(4)
      Represents options issued before February 15, 2005 to “non-affiliates” of Smart
      Online, as that term is defined in Rule 144, pursuant to Rule 701, which options
      are not included in the Registration Statement on Form S-8 Smart Online filed
      and effective on May 3, 2005, but which may be included in a later registration
      statement on Form S-8.


59
 Index





(5)
      Represents option shares to be registered for resale pursuant to a registration
      statement on Form S-8 filed and effective on May 3, 2005, which are not owned
      by
      affiliates of Smart Online as that term is defined in Rule 144.





(6)
      Represents option shares to be registered for resale pursuant to a registration
      statement Form S-8 filed and effective on May 3, 2005, all of which are owned
      by
      affiliates of Smart Online as that term is defined in Rule 144.





(7)
      Represents shares registered for resale pursuant to the registration statement
      on Form S-1 which we intend to file prior to November 30, 2005. The shares
      are
      issuable upon exercise of currently exercisable warrants.





(8)
      Represents shares held by stockholders with whom Smart Online has entered into
      Lock-Up Agreements. Under these agreements, resale of shares covered by the
      Lock-Up Agreements were prohibited prior to October 1, 2005, and since October
      1, 2005 each such stockholder is able to sell or transfer up to 8.5% of the
      shares of Common Stock of that stockholder that are subject to the Lock-Up
      Agreement during each calendar month until September 30, 2006.





(9)
      Represents warrants held by investors who purchased warrants during 2004 with
      whom Smart Online has entered into Dribble Out Agreements which provide, in
      general, for a volume limitation that expires 18 months after effective date
      of
      the first registration statement that registers the shares for resale. These
      warrant shares were covered by Registration Statement No. 333-119385 which
      became effective February 15, 2005. Consequently, the 18-month volume limitation
      continues until August 15, 2006. Under these agreements, each such stockholder
      may sell or transfer up to 33 1/3 of such holder’s shares of Common Stock
      covered by the Dribble Out Agreements during any rolling 30-day period prior
      to
      August 15, 2006.





(10)
      Represents warrants held by investors who purchased warrants during 2005 with
      whom Smart Online has entered into Dribble Out Agreements which provide, in
      general, for a volume limitation that expire six months after the effective
      date
      of the registration statement of which this prospectus is a part. Under these
      agreements, commencing with the effective date of such registration statement,
      each such stockholder may sell or transfer up to 25% of such holder’s shares of
      Common Stock covered by the Dribble Out Agreements during any rolling 30-day
      period prior to the termination of the agreement. As of November 1, 2005, this
      registration statement has not been filed.





(11)
      Represents shares issuable pursuant to currently exercisable outstanding
      warrants and options held by persons with whom Smart Online has not entered
      into
      any Lock-Up Agreements or Dribble Out Agreements.





**(54)
      Our Securities May Be Subject to "Penny Stock" Rules, Which Could Adversely
      Affect Our Stock Price and Make It More Difficult for You to Resell Our
      Stock.**





The
      Securities and Exchange Commission has adopted rules that regulate broker-dealer
      practices in connection with transactions in penny stocks. Penny stocks are
      generally equity securities with a price of less than $5.00 (other than
      securities registered on certain national securities exchanges or quoted on
      NASDAQ, provided that reports with respect to transactions in such securities
      are provided by the exchange or quotation system pursuant to an effective
      transaction reporting plan approved by the Commission.)





The
      penny
      stock rules require a broker-dealer, prior to a transaction in a penny stock
      not
      otherwise exempt from those rules, to deliver a standardized risk disclosure
      document prepared by the Commission, which:





·
            Contains
                a description of the nature and level of risk in the market for penny
                stocks in both public offerings and secondary
                trading;


·
            Contains
                a description of the broker’s or dealer’s duties to the customer and of
                the rights and remedies available to the customer with respect to
                a
                violation to such duties or other
                requirements;


·
            Contains
                a brief, clear, narrative description of a dealer market, including
“bid”
                and “ask” prices for penny stocks and the significance of the spread
                between the bid and ask price;


·
            Contains
                a toll-free telephone number for inquiries on disciplinary
                actions;


·
            defines
                significant terms in the disclosure document or in the conduct of
                trading
                penny stocks; and


·
            Contains
                such other information and is in such form (including language, type,
                size, and format) as the Commission shall
                require.


·
            The
                broker-dealer also must provide, prior to effecting any transaction
                in a
                penny stock, the customer:


·
            with
                bid and offer quotations for the penny
                stock;


·
            the
                compensation of the broker-dealer and its salesperson in the
                transaction;


·
            the
                number of shares to which such bid and ask prices apply, or other
                comparable information relating to the depth and liquidity of the
                market
                for such stock; and


·
            Monthly
                account statements showing the market value of each penny stock held
                in
                the customer’s account.





In
      addition, the penny stock rules require that prior to a transaction in a penny
      stock not otherwise exempt from those rules; the broker-dealer must make a
      special written determination that the penny stock is a suitable investment
      for
      the purchaser and receive the purchaser’s written acknowledgment of the receipt
      of a risk disclosure statement, a written agreement to transactions involving
      penny stocks, and a signed and dated copy of a written suitability statement.
      These disclosure requirements will have the effect of reducing the trading
      activity in the secondary market for our stock because it will be subject to
      these penny stock rules. Therefore, stockholders may have difficulty selling
      those securities.


60
 Index





**Item
      3. Quantitativeand Qualitative Disclosures about
      Market Risk**





***Foreign
      currency exchange risk***





During
      2004, 2003, and 2002, all of our contracts and transactions were U.S. dollar
      denominated. As a result our results of operations and cash flows are not
      subject to fluctuations due to changes in foreign currency exchange
      rates.





***Interest
      rate sensitivity***





We
      had
      unrestricted cash and cash equivalents totaling $173,339, $101,486, and $26,940
      at December 31, 2004, 2003, and 2002, respectively. These amounts were invested
      primarily in demand deposit accounts and money market funds. The unrestricted
      cash and cash equivalents are held for working capital purposes. We do not
      enter
      into investments for trading or speculative purposes. Due to the short-term
      nature of these investments, we believe that we do not have any material
      exposure to changes in the fair value of our investment portfolio as a result
      of
      changes in interest rates. Declines in interest rates, however, will reduce
      future investment income.





**Item
      4. Controlsand Procedures**





Attached
      as exhibits to this Form 10-Q are certifications of our Chief Executive Officer
      (CEO) and Chief Financial Officer (CFO), which are required in accordance with
      Rule 13a-14 of the Securities Exchange Act of 1934, as amended (the "Exchange
      Act"). This “Controls and Procedures” section includes information concerning
      the disclosure controls and procedures evaluation referred to in the
      certifications. This section should be read in conjunction with the
      certifications for a more complete understanding of the topics
      presented.





**Evaluation
      of Disclosure Controls and Procedures**





Our
      Board
      of Directors approved disclosure controls and procedures (“Disclosure Controls”)
      based on the evaluation and recommendations of our Chief Executive Officer
      and
      Chief Financial Officer in connection with preparation of financial statements
      for the period covered by this Form 10-Q. Disclosure Controls are controls
      and
      procedures designed to reasonably assure that information required to be
      disclosed in our reports filed under the Exchange Act, such as this Form 10-Q,
      is recorded, processed, summarized and reported within the time periods
      specified in the U.S. Securities and Exchange Commission’s (SEC’s) rules and
      forms. Disclosure Controls are also designed to reasonably assure that such
      information is accumulated and communicated to our management, including the
      CEO
      and CFO, as appropriate to allow timely decisions regarding required
      disclosure.





The
      evaluation of our Disclosure Controls included a review of the controls’
objectives and design, our implementation of the controls and the effect of
      the
      controls on the information generated for use in this Form 10-Q. This type
      of
      evaluation will be performed on a quarterly basis so that the conclusions of
      management, including the CEO and CFO, concerning the effectiveness of the
      Disclosure Controls can be reported in our periodic reports on Form 10-Q and
      Form 10-K. The overall goals of our evaluation activities are to monitor our
      Disclosure Controls, and to modify them as necessary.





Based
      upon the Disclosure Controls evaluation, our CEO and CFO have concluded that,
      as
      of the end of the period covered by this Form 10-Q, our Disclosure Controls
      were
      effective to provide reasonable assurance that information required to be
      disclosed in our Exchange Act reports is recorded, processed, summarized and
      reported within the time periods specified by the SEC, and that material
      information relating to Smart Online is accumulated and communicated to
      management, including the CEO and CFO as appropriate to allow timely decisions
      regarding required disclosure.





**Internal
      Controls**





There
      have been no changes in our internal control over financial reporting that
      occurred during our last fiscal quarter that have materially affected, or are
      reasonably likely to materially affect, our internal control over financial
      reporting.





**Inherent
      Limitations on Effectiveness of Controls**





Our
      management, including the CEO and CFO, does not expect that our Disclosure
      Controls or our internal control over financial reporting will prevent or detect
      all error and all fraud. A control system, no matter how well designed and
      operated, can provide only reasonable, not absolute, assurance that the control
      system’s objectives will be met. The design of a control system must reflect the
      fact that there are resource constraints, and the benefits of controls must
      be
      considered relative to their costs. Further, because of the


61
 Index


inherent
      limitations in all control systems, no evaluation of controls can provide
      absolute assurance that misstatements due to error or fraud will not occur
      or
      that all control issues and instances of fraud, if any, within the company
      have
      been detected. These inherent limitations include the realities that judgments
      in decision-making can be faulty and that breakdowns can occur because of simple
      error or mistake. Controls can also be circumvented by the individual acts
      of
      some persons, by collusion of two or more people, or by management override
      of
      the controls. The design of any system of controls is based in part on certain
      assumptions about the likelihood of future events, and there can be no assurance
      that any design will succeed in achieving its stated goals under all potential
      future conditions. Projections of any evaluation of controls effectiveness
      to
      future periods are subject to risks. Over time, controls may become inadequate
      because of changes in conditions or deterioration in the degree of compliance
      with policies or procedures.





**PART
      II. OTHERINFORMATION**





**Item
      1. LegalProceedings**





Smart
      Online, Inc. v. Genuity, Inc. -
      Smart
      Online instituted this action against Genuity on May 22, 2001, in the Superior
      Court of Wake County, North Carolina, Civil Action No. 01-CVS-06277. Smart
      Online brought claims against Genuity for breach of contract, breach of express
      warranty, breach of implied warranty of merchantability, breach of warranty
      of
      fitness for a particular purpose, conversion, unfair and deceptive trade
      practices, negligent misrepresentation and fraud arising from Genuity’s failure
      to perform properly under contracts between the parties, from Genuity’s failure
      to return certain property belonging to Smart Online, and from certain
      representations made by Genuity with regard to the services needed by Smart
      Online under the contracts. On or about July 23, 2001, Genuity filed its answer
      to the complaint along with counterclaims against Smart Online. In its
      counterclaims, Genuity brought claims for breach of contract alleging that
      Smart
      Online failed to pay for the services rendered by Genuity. On October 22, 2002,
      the court denied Genuity’s request to dismiss Smart Online’s breach of contract
      claim, allowed Smart Online to amend its complaint to restate its claim for
      breach of contract, and dismissed Smart Online’s claims for breach of implied
      warranties. The parties were completing discovery and preparing for trial when
      the case was automatically stayed as a result of Genuity’s filing for
      bankruptcy. This case is still subject to the automatic stay.




On
        or
        about November 10, 2005, the Smart Online instituted a law suit in the General
        Court of Justice Superior Court Division in Wake County, North Carolina against
        X.C.L. Partners, Inc. (“XCL”) seeking a declaratory judgment determining that
        Smart Online did not enter into a contract with XCL and therefore has no
        contractual relationship with XCL. Smart Online filed such law suit in response
        to a letter dated November 3, 2005 from XCL’s attorneys alleging that the
        Company is in breach of a contract with XCL and demanding, at a minimum,
        $200,000 plus 121,667 shares of stock of Smart Online. Management has determined
        with the advice of legal counsel that the claim has no merit.
 
 Approximately
        three and a half years ago, Smart Online petitioned (as is required under
        French
        law) a court in France to allow Smart Online to liquidate Smart Online S.A.,
        a
        French subsidiary of Smart Online. As a result, Smart Online paid $113,057
        to
        Smart Online S.A. in settlement of all claims against Smart Online. Recently,
        Michael Nouri, the President and CEO of the Smart Online and the former
        President and CEO of Smart Online S.A., was sued personally as the legal
        representative of Smart Online S.A., which suit alleges that Smart Online
        S.A.
        suffered unspecified amounts of excess liabilities and seeks to hold Mr.
        Nouri
        personally responsible. The Liquidateur for Smart Online, S.A. has agreed
        to a
        proposal for settlement offered by Mr. Nouri in the amount of $15,000 Euros
        (approximately USD $18,750 based on an exchange rate of $1.27 USD per Euro).
        This agreement is subject to approval by the French court. There can be no
        assurance this agreement will result in a final settlement on these terms.
        The
        Board of Directors of Smart Online has authorized Smart Online to indemnify
        Mr.
        Nouri for the amount of any settlement and all legal costs and fees associated
        with the defense of Mr. Nouri in relation to this matter, because Mr.Nouri
        was
        acting on behalf of Smart Online in the liquidation of its French subsidiary.




**Item
      2. UnregisteredSales of Equity Securities and
      Use of
      Proceeds**





During
      July 2005, Smart Online sold 90,909 shares of its Common Stock to an existing
      investor for a price of $5.50 per share resulting in gross proceeds of $500,000.
      Also during July 2005, Smart Online sold an additional 36,363 shares to a new
      investor resulting in gross proceeds of $199,997. In connection with this
      financing, Smart Online incurred stock issuance costs of $70,000 to an entity
      introduced to Smart Online by an existing shareholder, Doron Roethler.




During
      August and September 2005, Smart Online sold 786,642 shares of its Common Stock
      to new and existing investors for a price of $5.50 per share resulting in gross
      proceeds of $4,326,531. In connection with this financing, Smart Online incurred
      stock issuance costs of $270,525 to an entity introduced to Smart Online by
      an
      existing shareholder, Doron Roethler.




Additionally,
      in connection with these offerings,
      Smart Online entered into Registration Rights Agreements with these shareholders
      under which Smart Online is required to file a registration statement with
      the
      SEC to register the shares sold in the offering on or before September 30,
      2005.
      We expect to file this registration statement prior to November 30, 2005. The
      late filing of the registration statement will require Smart Online paid a
      penalty to the selling security holders. We anticipate that this penalty will
      be
      approximately $18,000 if we file on November 30, 2005.




In
      October 2005 Smart Online entered into agreements with two foreign firms to
      provide investor relations services. In connection with these agreements, Smart
      Online paid each of the investor relations firms $250,000 and issued
      each of the firms 625,000 shares of our Common Stock. In addition to
      recording the $500,000 of investor relations expenses for the cash portion
      of
      the investor relations fee, we expect to incur non-cash expenses equal to the
      fair market value of the shares. Smart
      Online intends to register these shares in a registration statement on Form
      S-1
      that it expects will be filed prior to November 30, 2005.




These
      offerings were conducted pursuant to Rule 506 under Regulation D. All the
      investors are accredited investors. All the investors have prior experience
      investing in start-up technology companies. All the investors were provided
      access to all the information they deemed relevant to their investment
      decisions. All the investors had prior business dealings with one another or
      with Smart Online. Neither Smart Online nor any person acting on its behalf
      offered or sold the securities by any general solicitation or general
      advertising. A legend was placed on the stock certificates stating that the
      securities have not been registered under the Securities Act and cannot be
      sold
      or otherwise transferred without an effective registration or exemption from
      registration.





The
      proceeds from this offering will be used to fund Smart Online’s working capital
      requirements.





**Item
      3. DefaultsUpon Senior Securities**





Not
      applicable.





**Item
      4. Submissionof Matters to a Vote of Security
      Holders**





None.


62
 Index





**Item
      5. OtherInformation**





(1)
            None




**Item
      6. Exhibits**





**Exhibits**





The
      Exhibits listed in the Exhibit Index are incorporated herein by
      reference.





63
 Index





**SIGNATURES**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.





Dated:
      November 14, 2005








**Smart
                Online, Inc.**/s/
                Michael Nouri**Michael
                Nouri**
              **Principal
                Executive Officer****Smart
                Online, Inc.**/s/
                Scott Whitaker**Scott
                Whitaker**
              **Principal
                Financial Officer and****Principal
                Accounting Officer**














64
 Index


**SMART
      ONLINE, INC.**


**EXHIBIT
      INDEX**







**Exhibit**
              **Number**
            **Exhibit
                Description**
            **Form**
            **File**
              **Number**
            **Exhibit**
            **Filing**
              **Date**
            **Filed**
              **Herewith**3.1
            Amended
                and Restated
              Certification
                of Incorporation
            SB-2*
            333-119385
            3.1
            9/30/043.2
            Amended
                and Restated By-Laws
            SB-2*
            333-119385
            3.1
            9/30/0410.1
            2004
                Equity Compensation Plan
            SB-2*
            333-119385
            10.1
            9/30/0410.2
            2001
                Equity Compensation Plan
            SB-2*
            333-119385
            10.2
            9/30/0410.3
            1998
                Stock Option Plan
            SB-2*
            333-119385
            10.3
            9/30/0410.4
            Form
                of Reorganization Lock-up Proxy and Release Agreement dated 1/01/04
                between Online and stockholders of Smart Online
            SB-2*
            333-119385
            10.4
            9/30/0410.5
            Form
                of Lock-up Agreement dated 01/01/04, between Smart Online and stockholders
                of Smart Online
            SB-2*
            333-119385
            10.5
            9/30/0410.6
            Form
                of Subscription Agreement with lock-up provisions between Smart Online
                and
                investors
            SB-2*
            333-119385
            10.6
            9/30/0410.7
            Form
                of Registration Rights Agreement dated as of 02/01/04 between Smart
                Online
                and investors
            SB-2*
            333-119385
            10.7
            9/30/0410.8
            Employment
                Agreement dated 04/01/04 with Michael Nouri
            SB-2*
              Amendment
                1
            333-119385
            10.8
            11/24/0410.9
            Employment
                Agreement dated 04/01/04 with
              Henry
                Nouri
            SB-2*
              Amendment
                1
            333-119385
            10.9
            11/24/0410.10
            Employment
                Agreement dated 04/01/04 with Ronna Loprete
            SB-2*
              Amendment
                1
            333-119385
            10.10
            11/24/0410.11
            Employment
                Agreement dated 05/01/04 with Jose Collazo
            SB-2*
              Amendment
                1
            333-119385
            10.11
            11/24/0410.12
            Employment
                Agreement dated 05/01/04 with Anil Kamath
            SB-2*
              Amendment
                1
            333-119385
            10.12
            11/24/0410.13
            Security
                Agreement dated 10/13/03 with Smart Online as the Debtor and Michael
                Nouri, Henry Nouri, Thomas Furr, Ronna Loprete and Eric Nouri as
                the
                Secured Parties
            SB-2*
              Amendment
                1
            333-119385
            10.13
            11/24/0410.14
            $418,749.93
                Promissory Note dated 04/30/04 from Smart Online as the Debtor to
                Michael
                Nouri
            SB-2*
              Amendment
                1
            333-119385
            10.14
            11/24/0410.15
            $64,602.90
                Promissory Note dated 04/30/04 from Smart Online as the Debtor to
                Michael
                Nouri
            SB-2*
              Amendment
                1
            333-119385
            10.15
            11/24/0410.16
            $398,383.27
                Promissory Note dated 04/01/04 from Smart Online as the Debtor to
                Henry
                Nouri
            SB-2*
              Amendment
                1
            333-119385
            10.16
            11/24/0410.17
            $116,507.60
                Promissory Note dated 04/30/04 from Smart Online as the Debtor Thomas
                Furr
            SB-2*
              Amendment
                1
            333-119385
            10.17
            11/24/0410.18
            $92,500
                Promissory Note dated 04/30/04 from Smart Online as the Debtor to
                Ronna
                Loprete
            SB-2*
              Amendment
                1
            333-119385
            10.18
            11/24/0410.19
            $47,740.18
                Promissory Note dated 04/30/04 from Smart Online as the Debtor to
                Eric
                Nouri
            SB-2*
              Amendment
                1
            333-119385
            10.19
            11/24/0410.20
            Standstill
                and Interest Modification Agreement dated 12/22/04 with Michael
                Nouri
            SB-2*
              Amendment
                2
            333-119385
            10.20
            12/23/0410.21
            Standstill
                and Interest Modification Agreement dated 12/22/04 with Henry
                Nouri
            SB-2*
              Amendment
                2
            333-119385
            10.21
            12/23/0410.22
            Standstill
                and Interest Modification Agreement dated 12/22/04 with Thomas
                Furr
            SB-2*
              Amendment
                2
            333-119385
            10.22
            12/23/0410.23
            Standstill
                and Interest Modification Agreement dated 12/22/04 with Ronna
                Loprete
            SB-2*
              Amendment
                2
            333-119385
            10.23
            12/23/0410.24
            Standstill
                and Interest Modification Agreement dated 12/22/04 with Eric
                Nouri
            SB-2*
              Amendment
                2
            333-119385
            10.24
            12/23/04




65
 Index








10.25
            Amended
                and Restated Integration Program Agreement for Vmail and Internet
                Messenger Engine dated 04/30/03 with Smart IL, Ltd.
            SB-2*
              Amendment
                1
            333-119385
            10.25
            11/24/0410.26
            Amendment
                to Amended and Restated Integration Program Agreement dated 10/29/03
                with
                Smart IL, Ltd.
            SB-2*
              Amendment
                1
            333-119385
            10.25
            11/24/0410.27
            Form
                of Subscription Agreement with Smart Online and Year 2005
                investors
            
            
            
            
            X10.28
            Form
              of Dribble-Out Agreement between Smart Online and Year 2005
              investors
            
            
            
            
            X10.29
            Form
                of Registration Rights Agreement between Smart Online and Year 2005
                investors
            
            
            
            
            X10.30
            Asset
                Purchase Agreement dated as of October 4, 2005 by and among Smart
                Online,
                Inc., SmartCRM, Computility, Inc. and certain shareholders of Computility,
                Inc. (Nonmaterial schedules and exhibits identified in the Asset
                Purchase
                Agreement have been omitted pursuant to Item 601b.2 of Regulation
                S-K.
                Smart Online agrees to furnish supplementally to the Commission upon
                request by the Commission a copy of any omitted schedule or
                exhibit.)
            Current
                report on Form 8-K
            001-32634
            2.1
            10/7/0510.31
            Stock
                Purchase Agreement dated as of October 17, 2005 by and among Smart
                Online,
                Inc., iMart Incorporated and the shareholders of iMart Incorporated.
                (Nonmaterial schedules and exhibits identified in the Stock Purchase
                Agreement have been omitted pursuant to Item 601b.2 of Regulation
                S-K.
                Smart Online agrees to furnish supplementally to the Commission upon
                request by the Commission a copy of any omitted schedule or
                exhibit.)
            Current
                report on Form 8-K
            001-32634
            2.1
            10/24/0510.32
            Employment
                Agreement dated as of October 17, 2005 by and among Smart Online,
                Inc.,
                iMart Incorporated and Gary Mahieu
            Current
                report on Form 8-K
            001-32634
            2.2
            10/24/0510.33
            Employment
                Agreement dated as of October 17, 2005 by and among Smart Online,
                Inc.,
                iMart Incorporated and Randy Purdy.
            Current
                report on Form 8-K
            001-32634
            2.3
            10/24/0510.34
            Lock-Box
                Agreement dated as of October 17, 2005,  by and among Smart Online,
                Inc., iMart Incorporated and the Shareholders of iMart
                Incorporated.
            Current
                report on Form 8-K
            001-32634
            2.4
            10/24/0510.35
            Consulting
              Agreement, dated October 4, 2005, by and between Smart Online, Inc.
              and
              Berkley Financial Services Ltd.
            Current
                report on Form 8-K
            001-32634
            
            11/10/0510.36
            Consuting
              Agreement, dated October 26, 2005, by and between Smart Online, Inc.
              and
              General Investments Capital (GIC) Ltd.
            Current
                report on Form 8-K
            001-32634
            
            11/10/0531.1
            Certification
                of Principal Executive Officer of Periodic Report Pursuant to Rule
                13a-14(a) or Rule 15d-14(a)
            
            
            
            
            X31.2
            Certification
                of Principal Financial Officer of Periodic Report Pursuant to Rule
                13a-14(a) or Rule 15d-14(a)
            
            
            
            
            X32.1
            Certification
                of Principal Executive Officer of Periodic Report Pursuant to Rule
                13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 1350
            
            
            
            
            X32.2
            Certification
                of Principal Financial Officer of Periodic Report Pursuant to Rule
                13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 1350
            
            
            
            
            X





*Form
      SB-2 was later converted to Form S-1 by post-effective amendment No.
      1